Fundamentals of Corporate Finance, 3rd Edition Test Bank by Ace Test Banks

Fundamentals of Corporate Finance, 3rd Edition

Parrino, Kidwell, Bates

Fundamentals of Corporate Finance 3e

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Chapter 1: The Financial Manager and the Firm Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Resource Management 1. The financial manager is responsible for making decisions that are in the best interests of the firm's owners. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 2. A patent is a productive asset for a technology-based firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 3. Intangible assets generate most of a manufacturing firm's cash flows. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Resource Management 4. The most fundamental way that a business can grow in size is the reinvestment of cash flows or earnings. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 5. When a firm goes bankrupt, it will always be liquidated. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 6. Capital assets are generally short term in nature. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Budget Preparation AICPA: Resource Management 7. A good capital budgeting or investment decision is one in which the benefits are worth more to the firm than the cost of the asset. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Investment Decisions AICPA: Strategic/Critical Thinking 8. Financing decisions determine how firms raise cash to pay for their investments. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Budget Preparation AICPA: Resource Management 9. The dollar difference between a firm’s total current assets and total liabilities is called its net working capital. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 10. A sole proprietorship is an owner's only business. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 11. Corporations hold the majority of all business assets and generate the majority of business revenues and profits in the United States. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 12. Unlimited liability means that the owner of a firm is responsible for paying all the bills of the firm. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 13. The process of transferring ownership of a sole proprietorship is relatively easy compared to a public corporation. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 14. General partners in a business have limited liability with regard to their firm's obligations. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 15. C-Corporations do not have their income subject to double taxation. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 16. Privately held corporations are allowed to have stockholders. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 17. The treasurer of a corporation usually reports to the CFO of the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Reporting 18. The external auditors of the firm report their findings directly to the CFO of the firm. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Performance Measurement AICPA: Strategic/Critical Thinking 19. Maximizing revenue should be the goal of the firm. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 20. An agency conflict can arise when the agent of the firm is the sole owner of the firm. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 21. The owners of a firm are unaffected by agency costs. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Professional Demeanor 22. Corruption in business does not affect the growth of the financial markets. A) True B) False Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 23. To start a business, the owners need A) a market where there is demand for their product. B) a clear vision of what products or services they want to produce. C) the know-how to successfully market their product. D) all of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 24. A stakeholder is: A) someone geographically close to the firm's headquarters. B) someone who has a claim on the cash flows of the firm. C) some government agency. D) all of the above. Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 26. Which of the following is a stakeholder? A) An employee B) A lender C) The IRS D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 27. A trademark is an example of: A) a liquid asset. B) an intangible asset. C) a contingent asset. D) none of the above. Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 28. Which of the following is a basic source of funds for a firm? A) Debt B) Equity C) Asset liquidations D) Both A and B Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 29. The cash remaining with the firm after paying its operating expenses, making payments to creditors, and taxes is called: A) earnings per share. B) capital contributed in excess of par. C) residual cash flows. D) assets. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 30. Cash dividends are paid out of: A) residual cash flows. B) liquidated assets. C) long-term debt. D) all of the above. Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 31. Current liabilities are liabilities that: A) will be converted to cash within a year. B) must be paid within a year. C) will be converted to equity within a year. D) none of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Budget Preparation AICPA: Resource Management 32. The capital budgeting decision process addresses A) how a firm's day-to-day financial matters should be managed. B) how a firm should finance its assets. C) which productive assets a firm should purchase. D) all of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 33. Working capital management decisions help to determine: A) how a firm's day-to-day financial matters should be managed. B) how a firm should finance its assets. C) which productive assets a firm should purchase. D) all of the above. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 34. Capital budgeting decisions generally impact more on: A) the asset portion of the balance sheet. B) the short-term portion of the balance sheet. C) the current liability portion of the balance sheet. D) all of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Strategic/Critical Thinking 35. A good capital budgeting decision is: A) one in which the benefits of the project are equal to the cost of the asset. B) one in which the benefits of the project are less than the cost of the asset. C) one in which the benefits of the project are more than the cost of the asset. D) all of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 36. Financial markets in which equity and debt instruments with maturities greater than one year are traded are called: A) money markets. B) capital markets. C) Over the counter exchange. D) none of the above. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 37. The profitability of a firm can be negatively affected by: A) too much inventory. B) too little inventory. C) either A or B. D) neither A nor B. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 38. Which of the following business organizational form(s) subject(s) the owner(s) to unlimited liability? A) Sole proprietorship B) General partnership C) Corporation D) Both A and B Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 39. Which of the following business organizational form(s) create(s) a tax liability on income at the personal income tax rate? A) Sole proprietorship B) Partnership C) Corporation D) Both A and B Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 40. Which of the following business organizational form(s) is/are the easiest one(s) to raise capital? A) Sole proprietorship B) Partnership C) Corporation D) Both A and B Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 41. Which of the following owners is protected by limited liability? A) A sole proprietor B) A general partner C) Owner of a corporation D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 42. Which of the following cannot be engaged in managing the business? A) A sole proprietor B) A general partner C) A limited partner D) None of the above Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 43. Which form of business organization generate(s) the majority of business revenues and profits in the United States? A) Sole proprietorship B) Partnership C) Corporation D) Both A and B Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 44. Which organizational form best enables a firm to sell its securities to the market? A) Sole proprietorship B) Partnership C) Private corporation D) Public corporation Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Legal/Regulatory Perspective 45. Which of the following organizational forms is subject to the Securities and Exchange Commission (SEC) regulations? A) Sole proprietorship B) Partnership C) Private corporation D) Public corporation Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 46. Which organizational form best enables the owners of a firm to monitor the professional conduct of each other owners of the firm? A) Sole proprietorship B) Partnership C) Private corporation D) Public corporation Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 47. Which of the following is considered a hybrid organizational form? A) Sole proprietorship B) Partnership C) Corporation D) Limited liability partnership Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Resource Management 48. Which of the following reports directly to the owners of a firm? (Assume that the firm is a public corporation.) A) CFO B) CEO C) Board of directors D) Audit committee Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Resource Management 49. Which of the following is primarily responsible for managing all aspects of a firm’s financial side? A) CFO B) CEO C) Board of directors D) Audit committee Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Reporting; Internal Controls AICPA: Reporting; Resource Management 50. Which of the following is responsible for performing an independent audit of a firm's financial statements? A) CFO B) CEO C) CPA firm D) Audit committee Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Internal Controls; Reporting AICPA: Reporting 51. How is a CPA firm insulated from being pressurized by management? A) The audit committee approves hiring, firing, and paying fees to external auditors. B) The chairman of the board approves the external auditor's fees as well as the engagement letter. C) The IRS approves the external auditor's fees as well as the engagement letter. D) The CPA firm is not insulated from management. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Resource Management Who among the following is typically responsible for managing a large corporation’s financial function? A) The CEO B) The Chairman of the board C) The Vice-President - Production D) The CFO Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Performance Measurement AICPA: Strategic/Critical Thinking 53. Which of the following is an appropriate goal for a firm? A) Profit maximization B) Revenue maximization C) Stockholder’s wealth maximization D) Tax minimization Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 54. When analysts and investors determine the value of a firm's stock, they should consider: A) the size of the expected cash flows associated with owning the stock. B) the timing of the cash flows. C) the riskiness of the cash flows. D) all of the above. Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Strategic/Critical Thinking 55. If a firm establishes maximizing profits as the most important goal of the firm, which of the following would not be given proper consideration? A) Sales revenues B) Profits C) Risk of bankruptcy D) Cost of goods sold Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Strategic/Critical Thinking 56. Which of the following helps in maximizing stockholder’s wealth not usually account for? A) Risk. B) Government regulation. C) The timing of cash flows. D) Amount of cash flows. Ans: B

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Budget Preparation AICPA: Strategic/Critical Thinking Which of the following factors or activities can be controlled by the management of a firm? A) Capital budgeting B) The level of economic activity C) The level of market interest rates D) Stock market conditions Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 58. One reason for the existence of agency problems between managers and stockholders is that: A) there is a significant degree of separation between management and ownership. B) managers know how to manage the firm better than stockholders. C) stockholders have unreasonable expectations about managerial performance. D) none of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 59. Who among the following is the principal in the agency relationship of a corporation? A) A company engineer B) The CEO of the firm C) A stockholders D) The board of directors Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Legal/Regulation Perspective 60. _____ has (have) a legal responsibility to represent stockholders’ interests. A) A chairman B) A CEO C) A corporation’s board of directors D) all of the above Ans: C

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 61. An example of an agency cost is, A) a manager turning down a value-contributing project because of its risks. B) a manager expensing a lavish dinner on the company expense report. C) a manager using too little debt within the firm's capital structure because of the additional risk associated with debt. D) all of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication IMA: Business Economics AICPA: Leadership 62. Which of the following mechanisms can help to align the behavior of managers with the goals of stockholders? A) Well-designed management compensation B) Managerial labor market C) An independent board of directors D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AACSB: Analytic IMA: Internal Controls AICPA: Risk Analysis 63. If a firm has had an agency conflict which is reflected in a poor performing stock for a long period of time, then the firm may become a target of _____ A) an SEC investigation. B) a corporate raider. C) an IRS investigation. D) a bankruptcy lawyer. Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 64. Executives that repeatedly put their own interests before that of the firm may find that they have difficulty in finding another job after their current one. This is an example of A) the managerial labor market disciplining managers. B) the market for corporate control. C) the board of directors affecting the prospects of a manager. D) none of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Resource Management 65. Who among the following is responsible for setting an agenda at meetings of the board of directors? A) Chairperson of the board of directors B) President C) Nominating committee D) Manager Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Resource Management 66. A director who is not an employee of the firm is called A) an executive director. B) an inside director. C) an independent director. D) an official director. Ans: C

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective 67. Which of the following is NOT one of the strategies incorporated in the Sarbanes-Oxley Act of 2002? A) Attain greater board independence B) Establish compliance programs C) Establish ethics programs D) Dictate maximum compensation levels Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Reporting AICPA: Reporting 68. Which of the following unconditional powers does the audit committee have the authority to do? A) Audit the personal bank account of the CEO B) Question any person employed by the firm C) Audit the compensation files of firms in the same industry D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective 69. What is the major complaint concerning the Sarbanes-Oxley Act of 2002 by firms? A) The legislative maximum allowable compensation for a CEO. B) The legal requirement to disclose project information. C) The cost of compliance. D) The cost of maintaining an SEC employed officer at the firm's premises. Ans: C

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Legal/Regulatory Perspective 70. A society's ideas about what actions are right and wrong are termed as: A) rules and policies. B) ethics. C) laws. D) unwritten laws. Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Legal/Regulatory Perspective 71. The golden rule is an example of A) a current law. B) a civil law. C) an unworkable rule in financial markets. D) an ethical norm. Ans: D

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 72. An example of an economy that had trouble in establishing a stock market and attracting foreign investment is A) Russia. B) China. C) The Czech Republic. D) Japan. Ans: A

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Legal/Regulatory Perspective 73. Corruption in business A) creates inefficiencies in an economy. B) inhibits growth in an economy. C) slows the rate of economic growth in a country. D) all of the above Ans: D

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Ethics IMA: Business Applications AICPA: Legal/Regulatory Perspective 74. Which corporate officer, when he or she is guilty of serious misconduct, can subject the firm to the heavy losses in financial wealth? A) Marketing Manager B) CFO C) Chief Technology Officer D) Chief Risk Officer Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Ethics IMA: Business Applications AICPA: Legal/Regulatory Perspective 75. An officer of a firm who is a majority owner in a competing firm will probably be subject to A) an IRS audit. B) a conflict of interest with his stockholders. C) arbitrage profit returns to the SEC. D) an FBI investigation. Ans: B

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 76. _____ occur(s) when one party in a business transaction has information that is unavailable to the other parties in the transaction. A) Profits B) Information asymmetry C) Information efficiency D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Decision Analysis AICPA: strategic/critical Thinking 77. With regard to information, a central idea of fairness suggests that: A) decisions should be made on an even playing field. B) insiders should be able to trade whenever they want. C) insiders should never be able to trade. D) outsiders should not be allowed to trade since, by definition, they are at a disadvantage. Ans: A

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Ethics IMA: Business Applications AICPA: Legal/Regulatory Perspective 78. The legal system and market forces impose substantial costs on individuals and institutions that engage in unethical behavior. Which of the following would not be an example of the above? A) Financial losses B) Legal fines C) Agency conflicts D) Jail time Ans: C

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Format: Essay Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Performance Measurement AICPA: Industry/Sector Perspective 79. Explain what should be the goal of a firm. Ans: The goal of a firm should be to maximize stockholders’ wealth, which in most cases is equivalent to maximizing the price of the shares of the firm. Note that this is not the same as maximizing profits, since maximizing profits can occur while taking on too much risk (which can lower the value of the stockholders’ investment). Maximizing profits also does not take the timing of the profits into account. Profits, moreover, should not be confused with cash. Maximizing stockholders’ wealth is also not the same as minimizing risk, which can occur without taking any risks.

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AACSB: Ethics IMA: Performance Measurement AICPA: Strategic/Critical Thinking 80. Explain how agency costs might be found within a firm whose CEO owns no shares in the firm and whose compensation package is unaffected by the profits (cash or accounting profits) of the firm. Ans: Since the manager has no ownership interest in the firm, he/she has no incentive to make the cash profits of the firm as high as possible. In fact, he/she has a personal incentive to have the firm pay for as many personal luxuries as possible since his/her compensation package will be completely unaffected by the decision to purchase the luxuries. In a firm like the above, we might expect the firm to expend a material amount of resources on items that the manager should probably pay for ownself.

Format: Essay Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AACSB: Ethics IMA: Business Applications AICPA: Problem Solving and Decision Making 81. You have a friend who tells you that ethics are completely unimportant in business since a number of laws have been set up for us to know the rules of the game. Comment. Ans: Despite heavy regulation, the financial sector has a long and rich history of financial scandals. While a good many of the scandals are due to laws that have been disregarded, many of the scandals began as ethical lapses. This suggests that laws are not enough to preclude behavior that is detrimental to the well-functioning of the markets.

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Chapter 2: The Financial System and the Level of Interest Rates Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 1. The role of the financial system is to gather money from people, businesses and government that have funds to invest and to channel that money to those who need it. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 2. The financial system is nothing more than a collection of financial markets. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 3. Without a financial market, purchasing a house would require a cash purchase. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 4. Governments are the principal lender-savers in the economy. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 5. Businesses are the principal borrower-spenders in the economy. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 6. Direct financial markets could be broadly labeled as wholesale markets for funding. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 7. A privately held corporation securing a loan from its regional commercial bank is an example of a direct market transaction. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective 8. The law that prohibited commercial banks from engaging investment banking activities is the Financial Services Modernization Act of 1999. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective 9. Today, major money center banks in U.S have been allowed back to provide investment banking services. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 10. A primary market is any financial market in which owners of outstanding securities can resell them to other investors. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 11. The vast preponderance of securities sales on the New York Stock Exchange are secondary market transactions. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 12. The existence of an active secondary market for a security will help to enhance the price of that particular security in the primary market. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. The downside to a private placement transaction is that, it does not require the fees and expenses associated with an SEC registration. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 14. Brokers are market specialists who do not bear risk of ownership of securities. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 15. The term money market reflects the idea that the instruments traded in the money market are highly marketable and easily converted into cash. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. Equities with maturity of greater than one year are generally traded in the capital market. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 17. Most companies use indirect market from a financial institution to fund their needs. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 18. Business finance companies obtain the majority of their funds by selling equity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 19. The nominal rate of interest is the rate of interest that is adjusted for inflation. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20. Real rates of interest are perfectly observable. A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 21. It is impossible for the nominal rate of interest to be below the real rate of interest. A) True B) False Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 22. An economy with a large flow of funds requires: A) a lot of gold reserves. B) a frictionless market. C) an efficient financial system. D) all of the above. Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 23. Financial markets and financial institutions are both part of: A) the U.S. Treasury. B) the financial system. C) the SEC. D) none of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 24. Savings by _____ in small dollar amounts is the origin of much of the money that funds business loans in an economy. A) consumers B) the U.S. government C) small businesses D) none of the above Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 25. A financial system's primary concern is funneling money from: A) wealthy individuals to non-wealthy individuals. B) lender-savers to borrower-spenders. C) borrower-spenders to lender-savers. D) the government to wealthy individuals. Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 26. _____ are the principal lender-savers in the economy. A) Households B) Investment banks C) State governments D) Businesses Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 27. An important function of the financial system is: A) to direct money to the best investment opportunities in the economy. B) to allow the federal government to view all financial transactions. C) to help state governments to coordinate state tax levies. D) to direct the money from borrower-lenders to lender-savers. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. Direct financing occurs when: A) a lender-savers borrows directly from a borrower-spenders. B) a borrower-spenders borrows directly from a lender-savers. C) a lender-savers borrows from the federal government. D) a borrower-spenders borrows from the federal government. Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 29. Which of the following is a major participant in the direct financial market? A) Large corporations. B) Wealthy individuals. C) Investment banks. D) All of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 30. The major players in the direct financial markets are: A) investment banks. B) money center banks. C) regional banks. D) both A and B. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 31. What is the typical minimum denominated transaction size in the direct financial markets? A) $10,000. B) $100,000. C) $1,000,000. D) $10,000,000. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: FSA AICPA: Legal/Regulatory Perspective 32. Which of the following act is responsible for rolling back many of the rules against commercial banks offering investment banking activities? A) The Securities Act of 1933. B) The Securities Exchange Act of 1934. C) The Glass-Steagall Act of 1933. D) The Financial Services Modernization Act of 1999. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 33. Which of the following is a process by which investment bankers purchase new securities directly from the issuing company and resell them to the investors? A) Agency marketing. B) Underwriting. C) Distribution. D) Private placement. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 34. Stocks that are traded in the _____ are typically those of smaller and lesser known firms. A) National Stock Exchange B) New York Stock Exchange C) American Stock Exchange D) over-the-counter Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 35. The financial market where a new security is sold for the first time is: A) a primary market. B) a secondary market. C) an indirect financial market. D) none of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 36. Secondary financial markets are similar to: A) direct auction markets. B) new-car markets. C) used-car markets. D) direct financial market. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 37. If you just purchased a share of IBM through a New York Stock Exchange-based transaction, you participated in: A) a primary market transaction. B) a secondary market transaction. C) a futures market transaction. D) none of the above. Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 38. The ease with which a security can be sold and converted into cash is called: A) convertibility. B) liquidity. C) marketability. D) none of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 39. The presence of a financial market increases the marketability of a financial security by: A) essentially insuring the price of the security. B) reducing the transaction costs for selling the security. C) guaranteeing the accuracy of information produced by the issuer of the security. D) none of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 40. One of the main services offered by investment banks to companies is: A) helping companies sell new debt or equity issues in the security markets. B) making loans to companies. C) taking deposits from companies. D) all of the above. Ans: A

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 41. The NYSE is an example of: A) an over-the-counter market exchange. B) an organized exchange. C) a commodities exchange. D) all of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 42. Which of the following markets has no central trading location? A) A futures exchange. B) An over-the-counter market. C) An auction market. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 43. A highly liquid financial instrument with a maturity of 90 days would be traded in: A) the money market. B) the bond market. C) the stock market. D) none of the above. Ans: A

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 44. Money market instruments are generally issued by: A) firms in dire need of cash to maintain their credit rating. B) firms of the highest credit rating. C) firms of the lower credit ratings. D) all of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 45. The term money market is used because: A) firms that issue securities in this market are in dire need of cash. B) it is a market where stocks are converted into money. C) the instruments traded in this market are close substitutes for cash. D) none of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 46. If a firm needs to adjust its liquidity position, then it would participate in: A) the money market. B) the bond market. C) the stock market. D) the auction market. Ans: A

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 47. If a firm needs to finance a new corporate headquarters building, then it would most likely seek the funds in the: A) money market. B) capital market. C) futures market. D) all of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 48. The most common reason that corporate firms use the futures and options markets is: A) to hedge risk. B) to take risk. C) to make deposits. D) none of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. Which of the following theories states that security prices reflect all public information, but not all private information? A) Weak-form efficiency. B) Semistrong-form efficiency. C) Strong-form efficiency. D) Nominal-form efficiency. Ans: B

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. Which of the following theories states that security prices reflect all information, whether public or private? A) Weak-form efficiency. B) Semistrong-form efficiency. C) Strong-form efficiency. D) Nominal-form efficiency. Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 51. If your firm primarily borrows from commercial banks, then it primarily accesses the capital markets through: A) direct financing. B) indirect financing. C) a legal loophole that allows all commercial banks the ability to underwrite securities. D) none of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 52. The process of converting financial securities with one set of characteristics into securities with another set of characteristics is called: A) financial bundling. B) financial intermediation. C) financial disintermediation. D) none of the above. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 53. A line of credit to a corporation is like _____ to an individual. A) a term loan B) a bond C) a credit card D) a debit card Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 54. Which of the following is a primary investment vehicle for the funds in which life insurance companies must invest? A) CDs. B) Equity securities. C) Long-term corporate bonds. D) Both B and C. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 55. Casualty insurance companies sell: A) protection against loss of income in the event of the death of the insured. B) protection against loss of property from fire, theft, accidents, and other predictable causes. C) protection against a loss of pension revenue for retirees. D) all of the above. Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 56. Which of the following would not make up a major proportion of a pension fund investment portfolio? A) Commercial paper. B) Long-term corporate bonds. C) Stocks. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 57. A mutual fund is an example of: A) a line of credit. B) an endowment fund. C) an investment fund. D) a pension fund. Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 58. If a small business opts not to borrow funds from a commercial bank, then what will probably be its next best alternative? A) An insurance company. B) A pension. C) An investment fund. D) A business finance company. Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 59. The cost of borrowing money is called: A) inflation. B) return. C) interest. D) all of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 60. The nominal rate of interest is made up of: A) the real rate of interest. B) compensation for inflation. C) a commodity cross-index return. D) both A and B . Ans: D

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 61. The real rate of return can be justified, at a basic level, by: A) compensation for inflation. B) compensation for deferring consumption. C) compensation for the level of international borrowing. D) all of the above. Ans: B

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AACSB: Reflective Thinking IMA: Corporate Finance AICPA: Resource Management 62. If you are a borrower, which would you prefer to occur during the life of your loan? A) A level of inflation that is higher than that anticipated at the outset of the loan. B) A level of inflation that is lower than that anticipated at the outset of the loan. C) A level of inflation that is exactly as anticipated at the outset of the loan. D) No inflation at all Ans: A

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 63. If inflation is anticipated to be 5 percent during the next year, while the real rate of interest for a one-year loan is 5 percent, then what should the nominal rate of interest be for a risk-free one-year loan? A) 5 percent. B) 10 percent. C) 25 percent. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. The general level of interest rates tends to follow: A) deflation. B) the business cycle. C) the default cycle. D) all of the above. Ans: B

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 65. During an economic expansion, we would expect: A) interest rates to increase. B) interest rates to decrease. C) interest rates to remain the same. D) the cost of money to decrease. Ans: A

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Business Economics AICPA: Industry/Global Perspective 66. In the United States, the real rate of interest has historically been around: A) 1 percent. B) 3 percent. C) 5 percent. D) 7 percent. Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Analysis AACSB: Analytic IMA: Corporate Finance AICPA: Resource Management 67. If the supply of loanable funds decreases relative to the demand for those funds, then we would expect: A) interest rates to remain unchanged. B) interest rates to increase. C) interest rates to decrease. D) the cost of money to remain unchanged. Ans: B

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. If a firm sells common stock to the public for the very first time, it is known as _____. A) an underwriting B) an initial public offering C) a financial intermediation D) an origination Ans: B

Format: Essay Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective Learning Objective: LO 3 69. Explain why secondary markets are so important to businesses that need to raise capital? Ans: Secondary markets provide liquidity to the buyers of securities. They facilitate the sale of securities because they enable investors to buy and sell securities as frequently as they want. Secondary markets are important to corporations because investors are willing to pay higher prices for securities in primary markets if the securities have active secondary markets. This lowers the cost of capital for the corporations that issue securities.

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Chapter 3: The Financial System and the Level of Interest Rates Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Reporting AICPA: Measurement 1. Generally accepted accounting principles (GAAP) are a set of authoritative guidelines that define accounting practice at a particular point in time. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 2. Generally accepted accounting principles determine the rules for how a company can issue stocks to raise money. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AACSB: Analytic

IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. The cost principle assumes that the parties to a transaction are economically rational and are free to act independently of each other. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. The going concern assumption states that a business will be shutting down its operation in the near future. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 5. The balance sheet identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (shareholders' equity) that were used to buy the assets. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 6. The balance sheet identity can be stated as: Total assets = Total liabilities + Total stockholders' equity. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Measurement 7. In a balance sheet, assets are listed in order of their liquidity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Corporate Finance AICPA: Measurement 8. During rising prices, a company using the LIFO method assumes that the sale is from the newest, highest-cost inventory. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Corporate Finance AICPA: Resource Management 9. During rising prices, a company using the FIFO method will sell its newest, highest-cost inventory first. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Reporting AICPA: Reporting 10. Book value is the amount a firm paid for its assets at the time of purchase. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Reporting AICPA: Measurement 11. The net book value of an asset is the historical cost less the accumulated depreciation. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Corporate Finance AICPA: Resource Management 12. The current market value of an asset is the amount that a firm would receive for the asset if it were sold on the open market. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 13. Preparing a marked-to-market balance sheet is rather straightforward because it is easy to obtain market values for all assets and liabilities. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Reporting AICPA: Reporting 14. The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses that were needed to generate those revenues. A) True B) False Ans: A Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 15. Depreciation and amortization are examples of prepaid expenses. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 16. The net cash provided by operating activities is another term used for net income. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 17. Cash flows from operations are the net cash flows that support a firm's principal business activities. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 18. Cash flows from operating activities involve buying and selling of long-term assets. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Corporate Finance AICPA: Resource Management 19. Making and collecting loans, issuing and paying out on insurance contracts, and buying and selling debt or equity instruments of other firms are examples of financing activities. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AACSB: Analytic

IMA: Corporate Finance AICPA: Resource Management 20. Typical financing activities include cash payments on the principal of long-term debt, cash payments of dividends to shareholders, and cash purchases of treasury stock. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 21. The key financial statement that ties the other three statements together is the statement of cash flows, which summarizes changes in the balance sheet from the beginning of the year to the end. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 22. Rent and insurance are examples of depletion expenses. A) True B) False Ans: B

Format: True/False Learning Objective: LO 8 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 23. The average tax rate is the total taxes divided by the taxable income. A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 24. Which of the following sections do annual reports typically contain? A) Financial summary related to the past year's performance B) Information about the company, its products, and its activities C) Audited financial statements, including limited historical financial data D) All three of the above sections are included in the annual report. Ans: D

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Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 25. Annual reports are prepared by a firm's management to: A) communicate to its shareholders the firm's failures in the previous year. B) provide a good overview of the firm's financial and operating performance. C) highlight the performance of its chief competitors. D) provide a forecast of the economy in the coming years. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Reporting AICPA: Measurement 26. The generally accepted accounting principles (GAAP) are: A) rules that outline how a firm can operate ethically. B) rules on how the firm will be valued in the event of a merger. C) rules and procedures that define how companies are to maintain financial records and prepare financial statements. D) rules for how a company can issue stock to raise money. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Reporting AICPA: Measurement 27. Accounting standards prescribed by generally accepted accounting principles (GAAP) are important because: A) they make the financial statements of all firms standardized. B) they allow one to examine a firm's performance with ease over a period of time. C) they make it possible for management or analysts to compare a firm's performance with that of other competitors. D) All of the above. Ans: D

3-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AACSB: Analytic

IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. The assumption of arm's-length transaction states that: A) both parties to a transaction can act independently of each other and make economically rational decisions. B) both parties to a transaction must have had previous transactions. C) one of the parties to the transaction is a bank that has full knowledge of the firm's creditworthiness. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Application AACSB: Analytic

IMA: Business Economics AICPA: Industry/Sector Perspective 29. Your uncle, who has a second home in Bethany Beach, Delaware, is planning to sell it in the next few weeks. You are interested in buying this beachside property, so your agent negotiates a price for the house with your uncle's agent. This transaction is an example of: A) the cost principle. B) the assumption of arm's-length transactions. C) the realization principle. D) the going concern assumption. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Analytic

IMA: Budget Preparation AICPA: Industry/Sector Perspective 30. The going concern assumption implies that: A) a firm will continue to be in business for the foreseeable future. B) a firm will be going out of business in the near future. C) a firm will continue to operate in the near future, but only after being acquired by another firm. D) None of the above. Ans: A

3-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Cost Management AICPA: Strategic/Critical Thinking 32. The matching principle calls for the accountant of a firm to: A) identify an asset with each liability of the firm. B) associate the revenue generated from a sale to the costs or expenses incurred to produce the product. C) match each item of inventory with the historical cost at which it was acquired. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 33. Tyson Corporation bought raw materials on April 23, 2008 and also on July 2, 2008. Products produced during the months of May were sold in July. The firm uses FIFO to value its inventory. According to the matching principle, the firm's accountant should associate: A) the inventory acquired on July 2 with the products sold. B) the inventory acquired on April 23 with the products sold. C) neither of these dates is valid because the products were sold in July. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 34. According to the realization principle, revenue from a sale of a firm's products are recognized: A) when the products are shipped to the buyer. B) when the buyer orders the goods. C) when cash is realized from the sale of the products. D) at the time of the sale whether or not cash is actually received. Ans: D

3-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AACSB: Communication

IMA: Reporting AICPA: Reporting 35. On June 23, 2008, Mikhal Cosmetics sold $250,000 worth of its products to Rynex Corporation, with the payment to be made in 90 days on September 20. The goods were shipped to Rynex on July 2. The firm's accountants should recognize the sale on: A) June 23, 2008. B) July 2, 2008. C) September 20, 2008. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 36. The cost principle states that an asset should be recognized on the balance sheet: A) at the market value of the asset. B) at the market value less the accumulated depreciation on the asset. C) at its historical cost. D) at its historical cost plus the accumulated depreciation on the asset. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 37. Trekkers Footwear bought a piece of machinery on January 1, 2006 at a cost of $2.3 million, and the machinery is being depreciated annually at an amount of $230,000 for 10 years. Its market value on December 31, 2008 is $1.75 million. The firm's accountant is preparing its financial statement for the fiscal year end on December 31, 2008. The net value of the asset that should be reported on the balance sheet is: A) $2.3 million. B) $1.61 million. C) $230,000. D) $1.75 million. Ans: B

3-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AACSB: Communication IMA: Reporting AICPA: Reporting 38. The conventional way of preparing a balance sheet is to list all assets in the order of their: A) market value. B) risk. C) liquidity. D) historical cost. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Reporting 39. Petra, Inc., has $400,000 as current assets, $1.225 million as plant and equipment, and $250,000 as goodwill. In preparing the balance sheet, these assets should be listed in which of the following orders? A) Current assets, goodwill, and plant and equipment. B) Current assets, plant and equipment, and goodwill. C) Goodwill is not an asset and is not listed here. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AACSB: Analytic

IMA: Reporting AICPA: Measurement 40. When prices are rising, valuing ending inventory using the FIFO method rather than LIFO gives: A) inventory a higher value but lowers net income. B) inventory a lower value and also lowers net income. C) both inventory and net income a higher value. D) inventory a lower value and net income a higher value. Ans: C

3-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 41. When prices are falling, valuing inventory using the LIFO method rather than FIFO gives: A) inventory a higher value but lowers net income. B) inventory a lower value and also lowers net income. C) both inventory and net income a higher value. D) inventory a lower value and net income a higher value. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 42. Which of the following is NOT true about goodwill? A) It is an intangible asset. B) It represents the value of all unrecorded assets acquired in a merger. C) It equals the premium paid over the fair market value of the assets acquired in a merger. D) When goodwill appears on a firm's balance sheet, it reduces the firm's net worth by that amount. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Corporate Finance AICPA: Resource Management 43. Which of the following is NOT true about treasury stock? A) It is a firm's own shares repurchased in the market by the firm. B) It can be reissued under stock option and other employee benefit plans. C) It lowers the value of the company. D) It increases the net worth of the company. Ans: C

3-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 44. Maddux, Inc., has completed its fiscal year and reported the following information. The company had current assets of $153,413, net fixed assets of $412,331, and other assets of $7,822. The firm also has current liabilities worth $65,314, long-term debt of $178,334, and common stock of $162,000. Calculate the amount of retained earnings. A) $405,648 B) $243,648 C) $167,918 D) $573,566 Ans: C Feedback: Total assets = $153,413 + $412,331 + $7,822 = $573,566 Total liabilities = $65,314 + $178,334 = $243,648 Total stockholders' equity = Total assets – Total liabilities Total stockholders' equity = $573,566 – $243,648 = $329,918 Retained earnings = Total stockholders' equity – Common stock Retained earnings = $329,918 – $162,000 = $167,918

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 45. Galan Associates prepared its financial statement for 2008 based on the information given here. The company had cash worth $1,234, inventory worth $13,480, and accounts receivables worth $7,789. The company's net fixed assets are $42,331, and other assets are $1,822. It had accounts payables of $9,558, notes payables of $2,756, common stock of $22,000, and retained earnings of $14,008. How much long-term debt does the firm have? A) $54,342 B) $76,342 C) $12,314 D) $18,334 Ans: D Feedback: Current assets = $1,234 + $7,789 + $13,480 = $22,503 Total assets = $22,503 + $42,331 + $1,822 = $66,656 Current liabilities = $9,558 + $2,756 = $12,314 Total stockholders' equity = $22,000 + $14,008 = $36,008 Long-term debt = Total assets – Current liabilities – Total stockholders' equity Long-term debt = $66,656 – $12,314 – $36,008 = $18,334

3-15

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 46. Tumbling Haven, a gymnastic equipment manufacturer, provided the following information to its accountant. The company had current assets of $145,332, net fixed assets of $356,190, and other assets of $4,176. The firm has long-term debt of $76,445, common stock of $200,000, and retained earnings of $134,461. What amount of current liabilities does this firm have? A) $94,792 B) $505,678 C) $171,217 D) None of the above. Ans: A Feedback: Total assets = $145,332 + 356,190 + $4,176 = $505,698 Total stockholders' equity = $200,000 + $134,461 = $334,461 Current liabilities = Total assets – Long-term debt – Total stockholders' equity Current liabilities = $505,698 – $76,445 – $334,461 = $94,792

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 47. Teakap, Inc., has current assets of $1,456,312 and total assets of $4,812,369 for the year ending September 30, 2006. It also has current liabilities of $1,041,012, common equity of $1,500,000, and retained earnings of $1,468,347. How much long-term debt does the firm have? A) $1,844,022 B) $2,303,010 C) $2,123,612 D) $803,010 Ans: D Feedback: Total Stockholders' equity = $1,500,000 + $1,468,347 = $2,968,347 Long-term debt = Total assets – Current liabilities – Total Stockholders' equity Long-term debt = $4,812,369 – $1,041,012 – $2,968,347 = $803,010

3-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 48. Chandler Sporting Goods produces baseball and football equipment and lines of clothing. This year the company had cash and marketable securities worth $335,485, accounts payables worth $1,159,357, inventory of $1,651,599, accounts receivables of $1,488,121, short-term notes payable worth $313,663, and other current assets of $121,427. What is the company's net working capital? A) $3,596,632 B) $1,801,784 C) $2,123,612 D) $1,673,421 Ans: C Feedback: Total current assets = $335,485 + 1,488,121 + $1,651,599 + $121,427 = $3,596,632 Total current liabilities = $1,159,357 + $313,663 = $1,473,020 Net working capital = $3,596,632 – $1,473,020 = $2,123,612

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 49. Tre-Bien Bakeries generated net income of $233,412 this year. At year end, the company had accounts receivables of $47,199, inventory of $63,781, and cash of $21,461. It also had accounts payables of $51,369, short-term notes payables of $11,417, and accrued taxes of $6,145. The net working capital of the firm is A) $68,931. B) $63,510. C) $69,655. D) None of the above Ans: B Feedback: Total current assets = $21,461 + $47,199 +$63,781 = $132,441 Total current liabilities = $51,369 + $11,417 + $6,145 = $68,931 Net working capital = $132,441 – $68,931 = $63,510

3-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 50. Spartan, Inc., is a manufacturer of automobile parts located in Greenville, South Carolina. At the end of the current fiscal year, the company had net working capital of $157,903. The company showed accounts payables of $94,233, accounts receivables of $83,112, inventory of $171,284, and cash and marketable securities of $12,311. Calculate the amount of notes payables. (Assume that notes payable and accounts payable are the only two current liabilities of the company.) A) $14,571 B) $26,882 C) $15,471 D) None of the above Ans: A Feedback: Total current assets = $12,311 + $83,112 + $171,284 = $266,707 Net working capital = $266,707 – Total current liabilities = $157,903 Total current liabilities = $266,707 – $157,903 = $108,804 Total current liabilities = $108,804 = Accounts payable + Notes payable Notes payable = $108,804 – $94,233 = $14,571

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: business Economics AICPA: Industry/Sector Perspective 51. The major disadvantages of market-value accounting include: A) the difficulty in estimating the current value for some assets. B) the difficulty in applying some of the valuation models used to estimate market values. C) the resulting numbers are potentially open to abuse. D) All of the above are disadvantages of market-value accounting. Ans: D

3-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 52. Which of the following is the best example of how a market-value balance sheet item differs from the firm’s book-value balance sheet item? A) A firm issued long-term bonds five-years ago that currently sell for par value. B) A firm sold common stock twenty-years ago for $20.00 a share. The firm’s common stock is currently selling for $96.50 per share. C) A firm has $5 million of accrued liabilities on the books. D) A firm issued preferred stock ten-years ago. These shares of preferred stock currently are selling for par value. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 53. Which of the following statements is NOT a limitation associated with market valuation of balance sheet accounts? A) It can be difficult to identify the market value of an asset, particularly if there are few transactions involving comparable assets. B) The estimates of market value can involve complex financial modeling, and the resulting numbers can be open to manipulation and abuse. C) Marking to market provides decision makers with a better chance of making the correct economic decision, given the information available. D) Mark-to-market accounting can become inaccurate if market prices deviate from the “fundamental” values of assets and liabilities. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 54. Which of the following does NOT belong to an income statement? A) Depreciation expense B) Goodwill C) Extraordinary items D) Amortization expense Ans: B .

3-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Budget Preparation AICPA: Measurement 55. Which of the following is NOT a noncash item? A) Depreciation B) Taxes C) Prepaid expenses D) Prepaid taxes Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 56. Centennial Brewery produced revenues of $1,145,227 in 2008. It has expenses (excluding depreciation) of $812,640, depreciation of $131,335, and interest expense of $81,112. It pays an average tax rate of 34 percent. What is the firm's net income after taxes? Round your final answer to the nearest dollar. A) $120,140 B) $248,475 C) $79,292 D) $40,848 Ans: C Feedback: Earnings before taxes = $1,145,227 – ($812,640 + $131,335 + $81,112) = $120,140 Net income = $120,140 (1 – 0.34) = $79,292

3-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AACSB: Analytic

IMA: Reporting AICPA: Measurement 57. Simplex Healthcare had net income of $5,411,623 after paying taxes at 34 percent. The firm had revenues of $20,433,770.Its interest expense for the year was $1,122,376, while depreciation expense was $2,079,112. What was the firm's operating expenses excluding depreciation? Round your intermediate calculations and final answer to the nearest dollar. A) $8,199,429 B) $9,032,853 C) $9,321,805 D) None of the above Ans B : Feedback: Earnings before taxes = Net income / (1 – Tax rate) = $5,411,623 / (1 – 0.34) = $8,199,429 EBIT = EBT + Interest expense = $8,199,429 + $1,122,376 = $9,321,805 Revenues – Operating expenses – Depreciation = EBIT Operating expenses = Revenues – Depreciation – EBIT = $20,433,770 – $2,079,112 – $9,321,805 = $9,032,853

3-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AACSB: Analytic

IMA: Reporting AICPA: Measurement 58. Triumph Trading Company provided the following information to its auditors. For the year ended March 31, 2008, the company had revenues of $1,122,878, operating expenses (excluding depreciation and leasing expenses) of $612,663, depreciation expenses of $231,415, leasing expenses of $126,193, and interest expenses of $87,125. If the company's average tax rate was 34 percent, what is its net income after taxes? Round your final answer to the nearest dollar. A) $43,218 B) $65,482 C) $152,607 D) None of the above. Ans A : Feedback: EBIT = $1,122,878 – ($612,663 + $231,415 + $126,193) = $152,607 Earnings before taxes = ($152,607 – $87,125) = $65,482 Net income = $65,482 (1 – 0.34) = $43,218

3-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AACSB: Analytic

IMA: Reporting AICPA: Measurement 59. Parrino Corporation has announced that its net income for the year ended June 30, 2008, is $1,824,214. The company had an EBITDA of $5,174,366, and its depreciation and amortization expense was equal to $1,241,790. The company's average tax rate is 34 percent. What is the amount of interest expense for the firm? A) $2,763,961 B) $939,747 C) $1,187,720 D) $1,168,615 Ans: D Feedback: Amount EBITDA $5,174,366.00 Less: Depreciation and amortization 1,241,790.00 EBIT $3,932,576.00 Less: Interest 1,168,615.39** EBT $2,763,960.61* Less: Taxes (34%) 939,746.61 Net income $1,824,214.00 *EBT = Net income / (1 – Tax rate) = $1,824,214 / 0.66 = $2,763,960.61 **Interest = EBIT – EBT = $3,932,576 − $2,763,960.61 = $1,168,615.39

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 60. Arco Steel, Inc. generated total sales of $45,565,200 during fiscal 2010. Depreciation and amortization for the year totaled $2,278,260, and cost of goods sold was $27,339,120. Interest expense for the year was $9,641,300 and selling, general, and administrative expenses totaled $4,556,520 for the year. What is Arco’s EBIT for 2010? A) $9,641,300 B) $11,391,300 C) $13,275,030 D) $18,490,000 Ans: B Feedback: Net sales $ 45,565,200 Cost of goods sold 27,339,120 Gross Profit $ 18,226,080 Selling, general and administrative expenses 4,556,520 .

3-23

Fundamentals of Corporate Finance 3e

Depreciation and amortization Earnings Before Interest and Taxes (EBIT)

Test Bank

2,278,260 $ 11,391,300

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AACSB: Communication

IMA: Reporting AICPA: Reporting 61. Which of the following is an income statement item? A) Accounts payable B) Accrued taxes C) Retained earnings D) Selling and administrative expenses Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 62. Which of the following is NOT a cash flow from operating activities? A) Cash payments on the principal of long-term debt B) Payments for utilities and rent C) Payments to purchase raw materials D) Cash receipts from selling goods and services Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 63. Cash flows from financing activities include all but one of the following: A) Cash payments on the principal of long-term debt B) Buying and selling bonds or stock of other firms C) Cash purchases of treasury stock D) Cash proceeds from a bank loan Ans: B

3-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 64. Which of the following is NOT a cash flow from investing activities? A) Buying and selling bonds of other firms B) Buying or selling of land, buildings, and plant and equipment C) Cash payments of dividends to shareholders D) Buying and selling stocks of other firms Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AACSB: Communication

IMA: Reporting AICPA: Reporting 65. Trident Corporation had the following cash flows in the current year. Which of the following will be categorized under the financing activities section of the statement of cash flows? A) Rent on a warehouse amounting to $1.1 million B) Purchase of $125,000 worth of five-year bonds issued by Towson Utilities C) Preferred dividends of $330,000 paid to shareholders D) Lease income received on a piece of land Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 66. During 2008, Towson Recording Company increased its investment in marketable securities by $36,845, funded fixed assets acquisition by $109,455, and had marketable securities of $14,215 mature. What is the net cash provided by (used in) investing activities? A) $132,085 B) $145,940 C) –$132,085 D) –$145,940 Ans: C Feedback: Cash inflows from investing activities = $14,215 Cash outflows from investing activities = $36,845 + $109,455 = $146,300 Net cash flows used in investing activities = $14,215 – $146,300 = $(132,085)

3-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 67. Trident Manufacturing Company's treasurer identified the following cash flows during this year as significant. The company repaid existing debt of $425,110, while raising additional debt capital of $750,000. It also repurchased stock in the open markets for a total of $63,250 and paid $233,144 in dividends to its shareholders. What is the net cash provided by (used in) financing activities? A) $28,496 B) $91,746 C) –$28,496 D) –$91,746 Ans: A Feedback: Cash inflows from financing activities = $750,000 Cash outflows from financing activities = $425,110 + $63,250 + $233,144 = $721,504 Net cash flows from financing activities = $750,000 – $721,504 = $28,496

3-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 68. Super Grocers, Inc., provided the following financial information for the quarter ending September 30, 2006: Depreciation and amortization – $133,414 Net income – $341,463 Increase in receivables – $112,709 Increase in inventory – $81,336 Increase in accounts payables – $62,411 Decrease in marketable securities – $31,225 What is the cash flow from operating activities generated during this quarter by the firm? A) $308,458 B) $374,468 C) –$374,468 D) –$308,458 Ans: B Feedback: Statement of Cash Flows For the quarter ended on September 30, 2006 Operating Activities Net income $341,463 Additions (sources of cash) Depreciation and amortization 133,414 Increase in accounts payable 62,411 Decrease in marketable securities 31,225 Subtractions (uses of cash) Increase in accounts receivable (112,709) Increase in inventories (81,336) Net cash provided by operating activities $374,468

3-27

Fundamentals of Corporate Finance 3e

Test Bank

Reference 3-1: Use the following information to answer questions 69 - 71: Thunderbird Amusement Park—Balance Sheet as of June 30 Assets 2007 2008 Cash $ 13,221 $ 11,729 Accounts receivables 31,323 37,909 Inventory 77,244 91,617 Total current assets $121,788 $141,255 Fixed assets 444,712 563,323 Less: Accumulated depreciation (100,000) (172,487) Net fixed assets 344,712 390,836 Total assets $466,500 $532,091 Liabilities and Stockholders' Equity Accounts payable $ 38,549 $ 42,881 Notes payable 12,004 16,753 Deferred taxes 21,934 16,788 Total current liabilities $ 72,487 $ 76,422 Long-term debt 78,445 61,290 Common stock 125,000 175,000 Retained earnings 190,568 219,379 Total liabilities and stockholders' equity $466,500 $532,091 The company had a net income of $248,462, and depreciation expenses were equal to $72,487.

Reference: Ref 3-1 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 69. What is the firm's net cash flow from operating activities? A) $304,322 B) $299,176 C) $192,602 D) None of the above. Ans: B Feedback: Operating Activities Net income $248,462 Additions (sources of cash) Depreciation and amortization 72,487 Increase in accounts payable 4,332 Subtractions (uses of cash) Increase in accounts receivable (6,586) Increase in inventories (14,373) Decrease in deferred taxes (5,146) Net cash provided by operating activities $299,176

3-28

Fundamentals of Corporate Finance 3e

Test Bank

Reference: Ref 3-1 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 70. What is the firm's net cash flow from (used in) investing activities? A) $0 B) $46,124 C) –$46,124 D) None of the above Ans: C Feedback: Cash inflows from investing activities = $0 Cash outflows from investing activities = $390,836 − $344,712 = $46,124 Net cash flows from investing activities = –$46,124

Reference: Ref 3-1 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 71. What is the firm's cash flow from financing activities? A) –$66,405 B) $61,656 C) –$61,656 D) −$182,057 Ans: D Feedback: Cash inflows from financing activities = Increase in notes payable + Increase in common stock = $4,749 + $50,000 = $54,749 Net income – Dividends = Increase in retained earnings Increase in retained earnings = $219,379 − $190,568 = $28,811 Cash dividends = $248,462 – $28,811 = $219,651 Cash outflows from financing activities = Decrease in long-term debt + Cash dividends paid = $17,155 + $219,651 = $236,806 Net cash flows from financing activities = $54,749 – $236,806 = $(182,057)

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 72. Which of the following is a cash flow from investing activities? A) Cash payment of dividends to shareholders B) Cash from sale of products C) Purchase of plant and equipment D) Rent received from industrial property owned Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 73. Natural Lite, Inc. reported the following items during fiscal 2010. The firm purchased marketable securities of $87,500, paid down a long-term loan in the amount of $650,000, purchased $4,250,000 of new equipment. The firm also issued $6,250,000 of common stock, paid $350,225 in dividends to its common shareholders, and repurchased $1,250,000 of common stock in the open market. What is the net cash provided by financing activities? A) $4,575,210 B) $1,733,285 C) $3,999,775 D) $2,467,915 Ans: C Feedback: Cash inflows from financing activities = $6,250,000 Cash outflows from financing activities = $650,000 + $1,250,000 + $350,225 = $2,250,225 Net cash flows from financing activities = $6,250,000 – $2,250,225 = $3,999,775

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 74. Which of the following presents a summary of the changes in a firm’s balance sheet from the beginning of an accounting period to the ending of an accounting period? A) The statement of retained earnings B) The statement of working capital C) The statement of cash flows D) The statement of net worth Ans: C

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 75. Trimeton Corporation announced that in the year ended June 30, 2008, its earnings before taxes amounted to $2,367,045. Calculate its taxes using the following table. Round your final answer to the nearest dollar. Tax Rate Taxable Income 15% $0 to $50,000 25 50,001 – 75,000 34 75,001 – 100,000 39 100,001 – 335,000 34 335,001 – 10,000,000 35 10,000,001 – 15,000,000 38 15,000,001 – 18,333,333 35 More than $18,333,333 A) $804,795 B) $690,895 C) $713,145 D) None of the above Ans: A Feedback: Earnings before tax = $2,367,045 Tax rate 15% 25 34 39 34 35 38 35

Income $0 to $50,000 50,001 – 75,000 75,001 – 100,000 100,001 – 335,000 335,001 – 10,000,000 10,000,001 – 15,000,000 15,000,001 – 18,333,333 More than $18,333,333 Total taxes payable

Tax $

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

$804,795

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Budget Preparation AICPA: Measurement 76. Chartworth Associates' financial statements indicated that the company had EBITDA of $3,145,903. It had depreciation of $633,000, and its interest rate on debt of $1.25 million was 7.5 percent. Calculate the amount of taxes the company is likely to owe. Round your final answer to the nearest dollar. Tax Rate

Taxable Income

15% 25 34 39 34 35 38 35 A) $1,069,607 B) $1,037,732 C) $822,512 D) none of the above Ans: C Feedback: EBITDA Depreciation Interest EBT

$0 to $50,000 50,001 – 75,000 75,001 – 100,000 100,001 – 335,000 335,001 – 10,000,000 10,000,001 – 15,000,000 15,000,001 – 18,333,333 More than $18,333,333

Tax rate

$3,145,903 (633,000) (93,750) $2,419,153

Income

15% $0 to $50,000 25 50,001 – 75,000 34 75,001 – 100,000 39 100,001 – 335,000 34 335,001 – 10,000,000 35 10,000,001 – 15,000,000 38 15,000,001 – 18,333,333 35 More than $18,333,333 Total taxes payable

Tax

7,500 6,250 8,500 91,650 708,612

$822,512

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Hard Bloomcode: Application AACSB: Analytic

IMA: Reporting AICPA: Measurement 77. Chartworth Associates’ financial statements indicated that the company has EBITDA of $3,145,903. It had depreciation of $633,000, and its interest rate on debt of $1.25 million was 7.5%. The company is likely to owe $822,512 in taxes. What are the marginal and average tax rates for this company? Tax Rate

Taxable Income

15% $0 to $50,000 25 50,001 – 75,000 34 75,001 – 100,000 39 100,001 – 335,000 34 335,001 – 10,000,000 35 10,000,001 – 15,000,000 38 15,000,001 – 18,333,333 35 More than $18,333,333 A) 34%, 35% B) 35%, 34% C) 34%, 34% D) none of the above Ans: C Feedback: Marginal tax rate =34% Average tax rate =Total taxes payable ÷ Total Taxable income =$822,512 ÷ $2,419,153 =34%

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 78. Which of the following best represents cash flows to investors? A) Cash flow from operating activity, plus cash flow generated from net working capital B) Earnings before interest and taxes times 1 minus the firm’s tax rate C) Net income minus dividends paid to preferred stockholders. D) Cash flow from operating activity minus cash flow invested in net working capital minus cash flow invested in long-term assets. Ans: D

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Format: Multiple Choice Learning Objective: LO 8 Level of Difficulty: Medium Bloomcode: Application AACSB: Analytic

IMA: Budget Preparation AICPA: Measurement 79.

Clarity Music Company has a marginal tax rate of 34 percent and an average tax rate of 32 percent this year. It is planning to construct a new recording studio next year. The appropriate tax rate to be applied on the income generated from the new studio is: A) the average tax rate. B) the marginal tax rate. C) either one. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 8 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Corporate Finance AICPA: Measurement 80. Which of the following statements is true? A) Only 20 percent of interest income is taxable for a corporation. B) Dividend income is fully taxable. C) Interest paid on debt obligations is a tax-deductible business expense. D) Dividends paid to stockholders are a tax-deductible business expense. Ans: C

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Format: Multiple Choice Learning Objective: LO 8 Level of Difficulty: Medium Bloomcode: Analysis AACSB: Analytic

IMA: Reporting AICPA: Measurement 81. United Brands Corp. just completed their latest fiscal year. The firm had sales of $16,650,000. Depreciation and amortization was $832,500, interest expense for the year was $825,000, and selling general and administrative expenses totaled $1,665,000 for the year, and cost of goods sold was $9,990,000 for the year. Assuming a federal income tax rate of 34%, what was the United Brands net income after-tax? A) $2,202,750 B) $1,745,325 C) $3,505,100 D) $2,813,000 Ans: A Feedback: United Brands Corp. Net sales $ 16,650,000 Cost of goods sold 9,990,000 Gross Profit $ 6,660,000 Selling, general and administrative expenses 1,665,000 Depreciation and amortization 832,500 Earnings Before Interest and Taxes (EBIT) $ 4,162,500 Interest expense 825,000 Earnings Before Taxes (EBT) $ 3,337,500 Income Taxes 1,134,750 Net Income after-tax $ 2,202,750

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Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Reporting 82. Identify and explain the five fundamental principles that form the basis of accounting standards in United States. Ans: The U.S. GAAP is based on a set of five principles. These include the assumption of arm's-length transaction, the cost principle, the realization principle, the matching principle, and the going concern assumption. • The assumption of arm's-length transaction assumes that the two parties involved in a transaction have the ability to make economic decisions independently and rationally without having any influence on the other party's decision making. • The cost principle calls for recording the value of an asset at its cost at the time of acquisition. At any point in time, the book value represents a fair value of the asset. This book value is determined by depreciating the cost of the asset over its estimated useful life. •

The realization principle reflects the fact that the revenue from a sale is recognized only when the sale of a firm's product or service is virtually completed and can be reliably confirmed.

•

The matching principle requires that any revenue generated from a sale is matched with the costs associated with producing the revenue. The going concern assumption refers to the idea that a firm is expected to continue functioning for a foreseeable future.

•

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Format: Essay Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 83. Explain the differences while using FIFO versus LIFO method of valuation in accounting for inventory. Ans: There are two common approaches that firms can use to value inventory. The first one is referred to as FIFO, or first-in, first-out, which requires a firm making a sale to associate the sale with the oldest inventory on the balance sheet. The second method is called LIFO, or last-in, first-out, and the firm using this approach is required to associate any sale with the newest inventory on the balance sheet. Although firms may switch from one approach to another, the switch cannot occur except under extraordinary circumstances. Choosing one approach over the other has an impact on a firm's balance sheet and the income statement, especially during the time of changing prices. When prices are rising, a firm using FIFO accounting has a lower cost of goods sold and a higher net income. In addition, the ending inventory will be valued at the more recent cost, which will result in a higher inventory value on the balance sheet. When prices are declining, firms using LIFO will benefit because LIFO provides the highest inventory valuation and net income.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Measurement 84. What are the advantages and disadvantages of using market-value accounting? Ans: Using market-value method of accounting to prepare financial statements has several advantages. Having current information about a firm's financial condition and the information about expected cash flows a company can generate, will allow a firm's management to make better decisions. It allows investors and creditors to better evaluate the firm, and it improves its ability to raise capital. There are also some negatives associated with market-value accounting. First of all, assessing the market value of some of the assets becomes quite difficult, and accountants would wary of making estimates. Second, the valuation models used in practice are not easy to use and could result in unreliable values. Third, unscrupulous executives could very well use these estimates to their advantage.

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Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Communication

IMA: Reporting AICPA: Reporting 85. Explain the following income statement items. a. Amortization expense b. Extraordinary items c. EBITDA Ans: a. Amortization expense is similar to depreciation; however it is concerned with intangible assets. Just as depreciation is used to write off the cost of real assets such as plant and equipment, amortization is used for writing off expenses for intangible assets—such as patents, licenses, copyrights, trademarks, and goodwill. The costs are assigned to the fiscal periods in which the firm is assumed to have benefited from these intangible assets. b. Extraordinary items are also expenses that are unusual and unlikely to occur frequently. These are gains or losses that do not arise from operations but because of occurrences such as floods, fires, and earthquakes. c. EBITDA is the acronym of earnings before interest, taxes, depreciation, and amortization. It represents a firm's earnings after accounting for cost of goods sold, but not expenses related to the asset base that was used to produce the revenues for the firm. The higher the value of the EBITDA, the more efficient the firm’s operations are.

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AACSB: Analytic

IMA: Reporting AICPA: Reporting 86. Identify the noncash items that a firm may have on its financial statements and explain their impact on the shareholders of the firm. Ans: Several noncash items can be found on a firm's financial statement. Although some firms may have all of these items, others may not. But one noncash item that all firms will have is the depreciation. This is typically the largest noncash item. Another noncash item is amortization. Other noncash items include the following: • Depletion charges, which are similar to depreciation but apply to extractive natural resources, such as crude oil, natural gas, timber, and mineral deposits. • Deferred taxes, which are the portion of a firm's income tax expense that is postponed because of differences in the accounting policies adopted for management financial reporting and tax reporting. • Prepaid expenses, such as prepaid rent and insurance. • Deferred revenues, which are revenues received as cash but not yet earned. An example of deferred revenue would be subscriptions received in advance towards magazines by a publishing company. The noncash expenses on a firm's income statement reduce the taxable income and hence the tax paid by the firm. This in turn increases the cash flow available to its shareholders. Noncash revenue items reduce the cash flow available to the firm but are typically nowhere near the magnitude of the largest noncash expenses.

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Chapter 4: Analyzing Financial Statements Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 1. Financial statement analysis can help us determine why a firm's cash flows are increasing or decreasing. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 2. Stockholders are primarily concerned on the value of their stock, but not on how much cash they can expect to receive from dividends and/or capital appreciation over time. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 3. Managers' decisions regarding financing, investment, and working capital are reflected in the financial statements. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic

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IMA: FSA AICPA: Measurement 4. A financial statement analysis conducted over a period of time is called trend analysis. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 5. A typical way in which a common-size income statement is constructed is by dividing all expense items in an income statement by net income. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 6. The most frequent method used for creating a common-size balance sheet is to divide each of the accounts by total assets, expressing each account as a percentage of total assets. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 7. Liquidity ratios are concerned with a firm's ability to pay its current bills without putting the firm in financial difficulty. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 8. A firm's current ratio changed from 1.4 times in the previous year to 1.6 times in the current year. Based on this information, we can conclude that the firm's liquidity has improved. A) B) Ans:

True False A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 9. A company can improve its liquidity by increasing its accounts payable, while maintaining the other accounts constant. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 10. The purchase of additional inventory by a firm should decrease a firm's quick ratio. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA

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AICPA: Measurement 11. Turnover ratios are useful for managers in identifying inefficient use of current and long-term assets. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 12. A firm increased its day’s sales outstanding from 35 days to 43 days. This implies the firm is more efficient in collecting the debts. A) True B) False Ans: B Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 13. Total asset turnover is more relevant for service-industry firms, while the fixed asset turnover ratio is more relevant for manufacturing industry firms. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 14. Financial leverage refers to the use of preferred stock in a firm's capital structure. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 15. The equity multiplier of a firm is computed by dividing the total equity by its total assets. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 16. The higher the times-interest-earned ratio, the more comfortable a firm is in meeting its interest obligations. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: FSA AICPA: Measurement 17. For a given share price of a firm's stock, the lower the EPS the lower the price-earnings ratio. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 18. A firm that has no debt will have its return on assets (ROA) equal to its return on equity (ROE). A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: FSA AICPA: Measurement 19. For a given level of after-tax income, the lower the level of equity a firm has, the higher the return on equity its shareholders will earn. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 20. The DuPont equation relates a firm's net profit margin, total asset turnover ratio, and equity multiplier to determine its return on equity. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 21. Firms with a lower return on assets (ROA) and higher leverage will have a lower return on equity (ROE) than firms with a higher return on assets (ROA) and lower leverage. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 22. In a peer group analysis, the benchmark for financial statement analysis is the performance of a competitor that is roughly the same size and that offer a similar range of products. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehenison AASCB: Analytic IMA: FSA AICPA: Measurement 23. While doing an industry group analysis, you form the comparison group by choosing firms that are larger than the firm being compared. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement

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24. The Standard Industrial Classification (SIC) codes are four-digit numbers in which the last two digits describe the type of business or industry in which the firm is engaged. A) True B) False Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 25. The three different perspectives on financial statement analysis are those of the: A) manager, regulator, and bondholder. B) manager, shareholder, and creditor. C) regulator, shareholder, and creditor. D) shareholder, creditor, and regulator. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 26. Shareholders analyze financial statements in order to: A) assess the cash flows that the firm will generate from its operations. B) determine the firm's profitability, their return for that period, and the dividend they are likely to receive. C) focus on the value of the stock they hold. D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 27. The creditors of a firm analyze financial statements so that they can focus on: A) the firm's amount of debt. B) the firm's ability to generate sufficient cash flows to meet its legal obligations first and still have sufficient cash flows to meet debt repayment and interest payments.

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C) the firm's ability to meet its short-term obligations. D) All of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 28. A firm's management analyzes financial statements so that: A) they can get feedback on their investing, financing, and working capital decisions by identifying trends in the various accounts that are reported in the financial statements. B) similar to shareholders, they can focus on profitability, dividend, capital appreciation, and return on investment. C) they can get more stock options. D) Both a and b Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 29. Anyone analyzing a firm's financial statements should: A) use audited financial statements. B) do a trend analysis. C) perform a benchmark analysis. D) All of the above. Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 30. An individual analyzing a firm's financial statements should do all but which one of the following? A) Use unaudited financial statements B) Perform a trend analysis C) Perform a benchmark analysis D) Compare the firm's performance to that of its direct competitors Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 31. Which of the following is NOT true of common-size balance sheets? A) Each asset and liability item on the balance sheet is standardized by dividing it by total assets. B) Balance sheet accounts are represented as percentages of total assets. C) Each asset and liability item on the balance sheet is standardized by dividing it by sales. D) Common-size balance sheets allow us to make meaningful comparisons between the balance sheets of two firms that are different in size. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 32. Which of the following is NOT true of common-size income statements? A) Each income statement item is standardized by dividing it by total assets. B) Income statement accounts are represented as percentages of net sales. C) Each income statement item is standardized by dividing it by net sales. D) Common-size income statements analysis is a specialized application of ratio analysis. Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 33. Common-size financial statements: A) are a specialized application of ratio analysis. B) allow us to make meaningful comparisons between the financial statements of two firms that are different in size. C) are prepared by having each financial statement item expressed as a percentage of some base number, such as total assets or total revenues. D) All of the above are true. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 34. Which of the following is a benefit of a common-size income statement? A) It is very useful to assess how effectively a firm collected its accounts receivable. B) It reveals a great deal of information about the adequacy of a firm’s net working capital. C) It can tell the analyst a great deal about a firm’s efficiency and profitability. D) It reveals how effectively a firm has increased its assets. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 35. Which of the following is true of ratio analysis? A) A ratio is computed by dividing one balance sheet item or income statement item by another. B) The choice of the scale determines the story that can be garnered from the ratio. C) Ratios can be calculated based on the type of firm being analyzed or the kind of analysis being performed. D) All of the above are true. Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 36. Which of the following is NOT true of liquidity ratios? A) They measure the ability of a firm to meet short-term obligations with short-term assets without putting the firm in financial trouble. B) There are two commonly used ratios to measure liquidity—current ratio and quick ratio. C) For manufacturing firms, quick ratios will tend to be much larger than current ratios. D) The higher the liquidity ratios, the more liquid the firm and the better its ability to pay its short-term bills. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 37. Which of the following is true about the quick ratio? A) The quick ratio is calculated by dividing the least liquid of current assets by current liabilities. B) Service firms that tend not to carry too much inventory will see significantly higher quick ratios than current ratios. C) Inventory, being not very liquid, is subtracted from total current assets to determine the most liquid assets. D) Quick ratios will tend to be much larger than current ratio for manufacturing firms or other industries that have a lot of inventory. Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 38. Which of the following does NOT change a firm's current ratio? A) The firm collects its accounts receivables. B) The firm purchases inventory by taking a short-term loan. C) The firm pays down its accounts payables. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 39. All else being equal, which of the following will decrease a firm's current ratio? A) A decrease in the net fixed assets B) A decrease in depreciation expense C) An increase in accounts payable D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 40. Which of the following is NOT true about the inventory turnover ratio? A) It is calculated by dividing inventory by cost of goods sold. B) It measures how many times the inventory is turned over into saleable products. C) The more times a firm can turnover its inventory, the better. D) Too high a turnover or too low a turnover could be a warning sign. Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension

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AASCB: Analytic IMA: FSA AICPA: Measurement 41. Which one of the following statements is NOT true? A) The accounts receivables turnover ratio measures how quickly the firm collects its credit sales. B) One ratio that measures the efficiency of a firm's collection policy is day’s sales outstanding. C) The more days that it takes a firm to collect on its receivables, the more efficient the firm is. D) Day’s sales outstanding measures in days, the time a firm takes to convert its receivables into cash. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 42. Which of the following statements is NOT true of the asset turnover ratio? A) Asset turnover ratio measures the dollar amount of sales per dollar of assets that the firm has. B) The fixed assets turnover ratio is less significant for equipment-intensive manufacturing industry firms than the total assets turnover ratio. C) The higher the total asset turnover, the more efficiently management is using total assets. D) The ratio is quite useful in identifying the inefficient use of current and long-term assets. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 43. Which of the following statements is correct? A) The lower the level of a firm's debt, the higher the firm's leverage. B) The lower the level of a firm's debt, the lower the firm's equity multiplier. C) The lower the level of a firm's debt, the higher the firm's equity multiplier. D) The tax benefit from using debt financing reduces a firm's risk. Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: FSA AICPA: Measurement 44. If firm A has a higher debt-to-equity ratio than firm B, then: A) firm A has a lower equity multiplier than firm B. B) firm B has a lower equity multiplier than firm A. C) firm B has higher financial leverage than firm A. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 45. Which one of the following statements is NOT correct? A) A leveraged firm is riskier than a firm that is not leveraged. B) A leveraged firm is less risky than a firm that is not leveraged. C) A firm that uses debt magnifies the return to its shareholders. D) A firm that does not use debt incurs opportunity cost of increasing value of shares. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 46. Coverage ratios, like times interest earned and cash coverage ratio, allow: A) a firm's management to assess how well they meet short-term liabilities. B) a firm's shareholders to assess how well the firm will meet its short-term liabilities. C) a firm's creditors to assess how well the firm will meet its interest obligations. D) a firm's creditors to assess how well the firm will meet its short-term liabilities other than interest expense. Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 47. Lionel, Inc., has current assets of $623,122, including inventory of $241,990, and current liabilities of $378,454. What is the quick ratio? Round your final answer to two decimal places. A) 1.65 B) 0.64 C) 1.01 D) None of the above Ans: C Feedback: Current assets = $623,122 Current liabilities = $378,454 Inventory = $241,990

Current assets - Inventory Current liabilities $623,122 − $241,990 = $378, 454 = 1.01

Quick ratio =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 48. Bathez Corp. has receivables of $334,227, inventory of $451,000, cash of $73,913, and accounts payables of $469,553. What is the firm's current ratio? Round your final answer to two decimal places. A) 1.83 B) 0.73 C) 1.67 D) None of the above Ans: A Feedback: Current assets = $73,913 + $451,000 +$334,227 = $859,140 Current liabilities = $469,553

Current assets Current liabilities $859,140 = $469,553 = 1.83

Current ratio =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 49. Zidane Enterprises has a current ratio of 1.92, current liabilities of $272,934, and inventory of $197,333. What is the firm's quick ratio? Round your final answer to two decimal places. A) 0.72 B) 1.20 C) 1.92 D) None of the above Ans: B Feedback: Current ratio = 1.92 times Current liabilities = $272,934 Inventory = $197,333

Current assets Current liabilites Current assets 1.92 = Current liabilites Current assets = 1.92  $272,934 = $524,033 Current assets - Inventory Quick ratio = Current liabilities $524, 033 − $197,333 = $272,934 = 1.20 Current ratio =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 50. Ronaldinho Trading Co. is required by its bank to maintain a current ratio of at least 1.75, and its current ratio now is 2.1. The firm plans to acquire additional inventory to meet an unexpected surge in the demand for its products and will pay for the inventory with short-term debt. How much inventory can the firm purchase without violating its debt agreement, if their total current assets equal $3.5 million? Round your final answer to the nearest dollar. A) $0 B) $777,777 C) $1 million D) None of the above Ans: B Feedback: Let "X" represent the additional borrowing against the firm's line of credit (which also equals the addition to current assets). We can solve for that level of "X" that forces the firm's current ratio to be at 1.75 $3,500,000 / Current liabilities = 2.1 Current liabilities = $1,666,667 1.75 = ($3,500,000 + X) / ($1,666,667 + X) (1.75 × $1,666,667) + 1.75X = $3,500,000 + X 0.75X = $3,500,000 − $2,916,667 X = $777,777

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 51. If Randolph Corp. has accounts receivables of $654,803 and net sales of $1,932,349, what is its accounts receivable turnover? Round your final answer to two decimal places. A) 0.34 times B) 1.78 times C) 2.95 times D) None of the above Ans: C Feedback: Accounts receivables = $654,803 Net sales = $1,932,349

Net sales Accounts receivables $1,932,349 = $654,803 = 2.95 times

Accounts receivables turnover =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 52. If Viera, Inc., has an accounts receivable turnover of 3.9 times and net sales of $3,436,812, what is its level of receivables? Round your final answer to the nearest dollar. A) $881,234 B) $13,403,567 C) $1,340,357 D) $81,234 Ans: A Feedback: Accounts receivables turnover = 3.9 times Net sales = $3,436,812 Accounts receivables turnover =

3.9 =

Accounts receivables =

= $881,234

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 53. Gateway Corp. has an inventory turnover ratio of 5.6. What is its day’s sales in inventory? Round your final answer to nearest day. A) 65 days B) 64 days C) 61 days D) 57 days Ans: A Feedback: Inventory turnover ratio = 5.6 times

Day ' s sales in inventory =

365 = 65.2 days 5.6

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 54. Jet, Inc., has net sales of $712,478 and accounts receivable of $167,435. What are the firm's accounts receivable turnover and day’s sales outstanding? Round your accounts receivable turnover to two decimal places and day’s sales outstanding to nearest day. A) 0.24 times; 79 days B) 4.26 times; 86 days C) 5.2 times; 61 days D) None of the above. Ans: B Feedback: Net sales = $712,478 Accounts receivable = $167,435

Net sales Accounts receivable $712, 478 = = 4.26 times. $167, 435

Accounts receivable turnover =

Day’s sales outstanding = 365 ÷ Accounts receivable turnover = 365 ÷ 4.26 = 85.7 days

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 55. Ellicott City Manufacturers, Inc., has sales of $6,344,210, and a gross profit margin of 67.3 percent. What is the firm's cost of goods sold? Round your final answer to the nearest dollar. A) $2,074,557 B) $2,745,640 C) $274,560 D) None of the above. Ans: A Feedback: Sales = $6,344,210 Gross profit margin = 67.3

Sales-Cost of goods sold Sales $6,344, 210 − Cost of Goods Sold 0.673 = $6,344,210 Cost of goods sold = $6,344, 210 − (0.673  $6,344, 210) = $2, 074, 557

Gross profit margin =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 56. Deutsche Bearings has total sales of $9,745,923, inventories of $2,237,435, cash and equivalents of $755,071, and day’s sales outstanding of 49 days. If the firm's management wanted its day’s sales outstanding (DSO) to be 35 days, by how much will the accounts receivable have to change? Round your final answer to two decimal places. A) $373,816.23 B) −$373,816.23 C) −$379,008.12 D) $379,008.12 Ans: B Feedback: Sales = $9,745,923; Inventory = $2,237,435 Cash and equivalents = $755,071; DSO = 49 Days

365 365 = Accounts recievable turnover Net sales/Accounts recievable 365  Accounts recievables DSO = Net sales DSO  Net sales 49  $9, 745,923 Accounts recievables = = 365 365 = $1,308,356.79 Target DSO = 35 Days DSO  Net sales 35  9, 745,923 New accounts recievables = = 365 365 = $934,540.56  Accounts recievables = $1,308,356.79-$934,540.56 -$373, 816.23 DSO =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 57. Trident Corp., has debt of $3.35 million with an interest rate of 6.875 percent. The company has an EBIT of $2,766,009. What is its times-interest-earned ratio? Round your final answer to nearest number. A) 13 times B) 12 times C) 11 times D) None of the above Ans: B Feedback: Debt = $3.35 million Interest Rate = 6.875 percent EBIT = $2,766,009 Interest expense = $3,350,000 × 0.06875 = $230,312.50

EBIT $2, 766, 009 = Interest expense $230,312.50 = 12 times

Times interest earned =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 58. Sectors, Inc., has an EBIT of $7,221,643 and interest expense of $611,800. Its depreciation for the year is $1,434,500. What is its cash coverage ratio? Round your final answer to two decimal places. A) 15.42 times B) 18.34 times C) 14.15 times D) None of the above Ans: C Feedback: Depreciation = $1,434,500 Interest expenses = $611,800 EBIT = $7,221,643

EBITDA EBIT + Depreciation = Interest expense Interest expense $7, 221, 643 + $1, 434,500 = $611,800 = 14.15 times

Cash coverage rates =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 59. Fahr Company had depreciation expenses of $630,715, interest expenses of $112,078, and an EBIT of $1,542,833 for the year ended June 30, 2006. What are the times interest earned and cash coverage ratios for this company? Round your final answers to one decimal place. A) 19.4 times; 12.7 times B) 17.3 time; 11.4 times C) 13.8 times; 19.4 times D) None of the above Ans: C Feedback: Depreciation = $630,715 Interest expenses = $112,078 EBIT = $1,542,833

EBIT $1,542,833 = Interest expense $112, 078 = 13.8 times

Times interest earned =

EBITDA EBIT + Depreciation = Interest expense Interest expense $1,542,833 + $630, 715 = $112, 078 = 19.4 times

Cash coverage rates =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 60. Your firm has an equity multiplier of 2.47. What is its debt-to-equity ratio? Round your final answer to two decimal places. A) 0.60 B) 1.47 C) 1.74 D) 3.47 Ans: B Feedback: Equity multiplier = 2.47 Equity multiplier = 1 + Debt-to-equity Debt-to-equity = Equity multiplier – 1 = 2.47 – 1 = 1.47

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 61. What will be a firm's equity multiplier given a debt ratio of 0.45? Round your final answer to two decimal places. A) 1.82 B) 1.28 C) 2.22 D) None of the above Ans: A Feedback: Debt Ratio = 0.45

Total assets 1 = Equity Equity / Total assets 1 1 = = 1 − Debt/Total assets 1 − 0.45 = 1.818

Equity multiplier =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard 62. Dreisen Traders has total debt of $1,233,837 and total assets of $2,178,990. What are the firm's equity multiplier and debt-to-equity ratio? Round your final answers to two decimal places. A) 2.31; 1.31 B) 1.75; 0.75 C) 0.75; 1.75 D) 1.31; 2.31 Ans: A Feedback: Debt = $1,233,837 Total Assets = $2,178,990 Debt ratio = $1,233,837 ÷ $2,178,990 = 0.57 Equity multiplier = Total assets ÷ Equity = 1 ÷ (Equity / Total assets) = 1 ÷ (1 – Debt / Total assets) = 1 ÷ (1 – 0.57) = 2.31 Equity multiplier = 1 + (Debt-to-equity) Debt-to-equity ratio = Equity multiplier – 1 = 2.31 – 1 = 1.31

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 63. RTR Corp. has reported a net income of $812,425 for the year. The company's share price is $13.45, and the company has 312,490 shares outstanding. Compute the firm's price-earnings ratio. Round your final answer to two decimal places. A) 4.87 times B) 8.12 times C) 5.17 times D) None of the above Ans: C Feedback: Net income = $812,425 Share price = $13.45 Shares outstanding = 312,490 EPS = $812,425 ÷ 312,490 = $2.60 per share

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 64. Perez Electronics Corp. has reported that its net income for 2006 is $1,276,351. The firm has 420,000 shares outstanding and a PE ratio of 11.2 times. What is the firm's share price? Round your intermediate and final answer to two decimal places. A) $34.05 B) $3.68 C) $11.20 D) $36.80 Ans: A Feedback: Net income = $1,276,351 Share outstanding = 420,000 EPS = $1,276,351 ÷ 420,000 = $3.04 per share PE ratio = 11.2 times Price-earnings ratio = Price per share ÷ EPS 11.2 = Price per share ÷ $3.04 Price per share = 11.2 × $3.04 = $34.05

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 65. Juventus Corp has total assets of $4,744,288, total debt of $2,912,000, and net sales of $7,212,465. Their net profit margin for the year is 18 percent. What is Juventus's return on assets (ROA)? Round intermediate calculations to nearest dollar and percentage answer to one decimal place. A) 25.6% B) 18% C) 27.4% D) None of the above Ans: C Feedback: Total assets= $4,744,288; Total debt= $2,912,000 Net sales= $7,212,465; Net profit margin= 18%

Net income Sales Net income = 0.18  $7, 212, 465 = $1, 298, 244

Net profit margin =

ROA =

Net income $1, 298, 244 = = 27.4% Total assets $4, 744, 288

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 66. GenTech Pharma has reported the following information: Sales/Total assets = 2.89; ROA = 10.74%; ROE = 20.36% What are the firm's profit margin and equity multiplier? Round your profit margin answer to one decimal place, and equity multiplier answer to 2 decimal places. A) 7.1%; 0.53 B) 7.1%; 1.90 C) 3.7%; 0.53 D) 3.7%; 1.90 Ans: D Feedback: Total assets turnover = 2.89 ROA = Net income ÷ Total assets = 10.74% ROE = Net income ÷ Total equity = 20.36% (1÷ROA) * Total assets turnover = 1 ÷ Profit margin 9.31 * 2.89 = 1 ÷ Profit margin Profit margin = 3.7% Equity multiplier = Total assets ÷ Total equity Equity multiplier = ROE ÷ ROA

Equity multiplier =

ROE 0.2036 = = 1.90 ROA 0.1074

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 67. Tigger Corp. has reported the financial results for the year-ended 2006. Based on the information given, calculate the firm's gross profit margin and operating profit margin. Round your final answers to one decimal place. Net sales = $4,156,700 Cost of goods sold = $2,715,334 A) 34.7%; 32.6% B) 32.6%; 18.7% C) 34.7%; 18.7% D) None of the above. Ans: A Feedback: Net sales = $4,156,700 Net income = $778,321 Cost of goods sold = $2,715,334 EBIT = $1,356,098

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

Net sales - Cost of goods sold Net sales $4,156, 700 − $2, 715,334 = = 34.6757% $4,156, 700

Gross profit margin =

Operating profit margin =

EBIT $1,356, 098 = = 32.6243% Net sales $4,156, 700

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 68. Andrade Corp has debt of $2,834,950, total assets of $5,178,235, sales of $8,234,121, and net income of $812,355. What is the firm's return on equity? Round your final answer to one decimal place. A) 7.1% B) 34.7% C) 28.1% D) 43.2% Ans: B Feedback: Debt = $2,834,950 Sales = $8,234,121 Total Assets = $5,178,235 Net Income = $812,355 Total equity = Total assets – Total liabilities = $5,178,235 − $2,834,950 = $2,343,285 Return on equity = Net income ÷ Total equity = ($812,355 ÷ $2,343,285 ) = 34.67%

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 69. Why is the quick ratio considered by some to be a better measure of liquidity than the current ratio? A) The quick ratio more accurately reflects a firm's profitability. B) It omits the least liquid current asset from the numerator of the ratio. C) The current ratio does not include accounts receivable. D) It measures how "quickly" cash flows through the firm. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 70. In the latest year, Photon, Inc. reported $276,000 in net income. The firm maintains a debt ratio of 30% and has total assets of $3,000,000. What is Photon's return on equity? (Round your percentage answer to one decimal place.) A) 13.1% B) 14.6% C) 22.5% D) 18.7% Ans: A Feedback: Net Income = $276,000 Debt Ratio = 30% Total assets = $3,000,000

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 71. Which of the following is true of a firm that has no debt in its capital structure? A) Its return on equity (ROE) will be greater than its return on asset (ROA). B) Its return on equity (ROE) will be lesser than its return on asset (ROA). C) Its return on equity (ROE) will be equal to its return on asset (ROA). D) None of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 72. Which of the following is true of a firm that has both debt and equity? A) Its return on equity (ROE) will be greater than its return on asset (ROA). B) Its return on equity (ROE) will be lesser than its return on asset (ROA). C) Its return on equity (ROE) will be equal to its return on asset (ROA). D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 73. Which one of the following statements is NOT correct? A) The DuPont system is based on two equations that relate a firm's return on asset (ROA) and return on equity (ROE). B) The DuPont system is a set of related ratios that links the items of balance sheet and the income statement. C) Both management and shareholders can use this tool to understand the factors that drive a firm's return on equity (ROE). D) All of the above are correct. Ans: D

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Measurement 74. The DuPont equation shows that a firm's (return on equity) ROE is determined by three factors: A) net profit margin, total asset turnover, and the equity multiplier. B) operating profit margin, return on assets (ROA), and the total assets turnover. C) net profit margin, total asset turnover, the return on assets (ROA). D) return on assets (ROA), total assets turnover, and the equity multiplier. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: FSA AICPA: Measurement 75. Which one of the following is a criticism of equating the goals of maximizing the return on equity (ROE) of a firm and maximizing the firm's shareholder wealth? A) ROE is based on after-tax earnings, not cash flows. B) ROE does not consider risk. C) ROE ignores the size of the initial investment as well as future cash flows. D) All of the above are criticisms of ROE as a goal. Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 76. Which one of the following is NOT an advantage of using return on equity (ROE) as a goal? A) ROE is highly correlated with shareholder wealth maximization. B) ROE and the DuPont analysis allow management to break down the performance and identify areas of strengths and weaknesses. C) ROE does not consider risk. D) All of the above are advantages of using ROE as a goal. Ans: C

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 77. Saunders, Inc., has a ROE of 18.7 percent, an equity multiplier of 2.53 times, sales of $2.75 million, and a total assets turnover of 2.7 times. What is the firm's net income? Round your final answer to two decimal places. A) $75,281.80 B) $514,250.00 C) $51,425.00 D) $7,528.10 Ans: A Feedback: ROE = 18.7 percent Equity multiplier = 2.53 times Sales = $2.75 million Total assets turnover = 2.7 times

Sales $2, 750, 000 = Total assets Total assets $2, 750, 000 2.7 = Total assets $2,750,000 Total assets = = $1, 018,518.52 2.7

Total assets turnover =

Total assets Equity $1, 018,518.52 2.53 = Equity $1, 018,519 Equity = = $402,576.49 2.53 EM =

Net income Equity Net income = ROE  Equity = 0.187  $402,577 = $75, 281.80 ROE =

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Measurement 78. Sorenstam Corp. has an equity multiplier of 2.34 times, total assets of $4,512,895, a ROE of 17.5 percent, and a total assets turnover of 3.1 times. Calculate the firm's ROA. Round your percentage answer to two decimal places. A) 6.23% B) 4.53% C) 7.48% D) 5.79% Ans: C Feedback: Equity multiplier = 2.34 times Total assets = $4,512,895 ROE = 17.5 percent Total assets turnover = 3.1 times

Sales Total assets Sales 3.1 = $4,512,895 Sales = 3.1 $4,512,895 = $13,989,975

Total assets turnover =

Total assets Equity $4,512,895 2.34 = Equity $4,512,895 Equity = = $1,928,588 2.34 EM =

NI Equity NI = ROE  Equity = 0.175  $1,928,588 = $337,503

ROE =

ROA =

NI $337,503 = = 7.48% Total assets $4,512,895

Format: Multiple Choice

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Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: FSA AICPA: Measurement 79. There are people who believe that the analysis of financial statements has limitations. Which of the statements below would qualify as a limitation of financial statement analysis? A) Ratio analysis requires the analyst to evaluate a firm’s performance over a period of time to be of any value. B) Proper ratio analysis requires the analyst to rely upon audited financial statements, which can be easily manipulated. C) Thorough ratio analysis requires the analyst to refer to benchmarking, which is very easy to misinterpret. D) Ratio analysis requires the analyst to utilize accounting data that is based on historical costs instead of current market values. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 80. Which one of the following statements about trend analysis is NOT correct? A) The benchmark for trend analysis is based on a firm's historical performance. B) It allows management to examine each ratio over time and determine whether the trend is good or bad for the firm. C) It uses the Standard Industrial Classification (SIC) System to benchmark firms. D) A ratio value that is changing typically prompts the financial manager to sort out the issues surrounding the change. Ans: C

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 81. Peer group analysis can be performed by: A) management choosing a set of firms that are similar in size or sales, or who compete in the same market. B) using the average ratios of this peer group, which would then be used as the benchmark. C) identifying firms in the same industry that are grouped by size, sales, and product lines in order to establish benchmark ratios. D) Only a and b relate to peer group analysis. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 82. Which of the following is NOT a method of “benchmarking”? A) Conducting an industry group analysis. B) Utilizing the DuPont system to analyze a firm’s performance. C) Evaluating a single firm’s performance over time. D) Identifying a group of firms that compete with the company being analyzed. Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehehension AASCB: Analytic IMA: FSA AICPA: Measurement 83. Which of the following is a limitation of ratio analysis? A) Ratios depend on accounting data based on historical costs. B) Differences in accounting practices like FIFO versus LIFO make comparison difficult. C) Trend analysis could be distorted by financial statements affected by inflation. D) All of the above are limitations of ratio analysis. Ans: D

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Format: Essay Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Analysis AASCB: Analytic IMA: FSA AICPA: Measurement 84. Compare how a firm's creditor would analyze a firm's financial statements relative to those of a firm's shareholders. Ans: A firm's creditors’ primary concern is the ability of the firm to repay their loans with interest on a timely manner. They analyze the firm's financial statements to gauge the ability of the firm to generate sufficient cash flows to meet not only the legal financial obligations, but also the creditors’ debt obligations. Shareholders, on the other hand, want to know how much cash they can expect to receive for their stocks, what their return on investment will be, and/or how much their stock is worth in the market.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 85. What are some of the main limitations of ratio analysis? Ans: While financial ratio analysis can provide management with useful information to improve a firm's performance, there are some serious limitations to its usefulness. First, ratio analysis depends on accounting data based on historical costs. Management or investors will get a truer picture of the firm's financial condition if market value is the basis of the analysis. Second, there is no theoretical backing in making judgments based on financial statement and ratio analysis. Judgment calls made based on experience or common sense will not work all the time. Third, when doing industry or peer group analysis you are often confronted with large, diversified firms that do not fit into any one SIC code or classification. Fourth, trend analysis could be distorted by financial statements affected by inflation. Finally, multinational firms deal with many accounting standards. Financial reports that are created based on different accounting standards make it difficult to compare. Even among domestic firms, differences in accounting practices, like FIFO versus LIFO, make comparison difficult.

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Measurement 86. Explain the different ways that a firm's ratios can be benchmarked. Ans: Benchmark data can be obtained in three different ways—trend analysis, industry average analysis, and peer group analysis. Trend analysis involves evaluating a single firm's performance over time. This sort of analysis allows management to see whether a given ratio value has increased or decreased over time and whether there has been any significant changes in the value of the ratios being analyzed. A ratio value that is changing typically is a signal to the financial manager to take a closer look at the ratio and to make decisions depending on whether the change is favorable or unfavorable to the firm. A second way to establish a benchmark is to conduct an industry group analysis. We do this by identifying a group of firms that have the same product line, compete in the same market, and are about the same size. The average ratio values for the group will be our benchmarks. The third way to establish benchmark information is to identify a group of firms that compete with the company you are analyzing. Ideally, the firms are in similar lines of business, are about the same size, and are direct competitors of the target firm. These firms form a peer group of firms in the same industry. Once a peer group has been identified, you can obtain their annual reports and compute average ratio values and can compare its performance with the competitors’.

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Chapter 5: The Time Value of Money Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 1. The time value of money is based on the belief that people have a positive time preference for consumption. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 2. The value of a dollar invested at a positive interest rate grows over time. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 3. The value of a dollar invested at a positive interest rate grows over time but at a slower rate further into the future. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 4. The further in the future you receive a dollar, the more it is worth today. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 5. The higher the rate of interest, the more likely you will elect to invest your funds and forgo current consumption. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 6. The future value technique uses discounting to find the future value of each cash flow at the end of a project's life. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 7. The process of converting the initial amount into future value is called discounting. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 8. Compounding is the process by which interest earned on an investment is reinvested so that in future periods, interest is earned on the interest previously earned as well as the original principal. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 9. Compound interest consists of both simple interest and interest on interest. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 10. Compound interest increases as the number of year decreases. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 11. Compounding accelerates the growth of the total interest earned. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 12. Due to compounding effects, the growth in the future value of an investment over time is linear. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 13. The growth in the future value of an investment over time is not linear, but exponential. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 14. William invested $5,000 in an account earning 10 percent for one year. If he had left his investment in that account for another two years, he would expect the total interest earned over the three years to be higher by exactly $1,000. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 15. The higher the interest rate on an investment, the more money that is accumulated for any time period. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 16. The more frequently the interest payments are compounded, the larger the future value of $1 for a given time period. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 17. If Bank A pays interest on a monthly basis and Bank B pays the same interest on a quarterly basis, then investing $1,000 in Bank B will lead to a higher future value than investing the same amount in Bank A. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 18. The future value of an investment of $5,000 earning an annual interest of 10 percent equals $6,000 at the end of one year. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 19. The future value of an investment of $5,000 to be received in three years at a discount rate of 10 percent is $6,655. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 20. The future value factor for 10 years at 15% is calculated as (1 + 0.15)10. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 21. To calculate the present value of a future amount, we divide the future amount by the future value factor. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 22. The present value is simply the current value of a future cash flow that has been discounted at an appropriate discount rate. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 23. The present value technique uses discounting to find the present value of each cash flow at the beginning of a project. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 24. The present value factor increases as the number of period decreases. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 25. The process of calculating the present value of a future cash flow is called compounding. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 26. The present value of $3,000 to be received in two years at a discount rate of 10 percent is $3,630. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comrpehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 27. The higher the discount rate, the lower the present value of a future cash flow. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 28. The farther in the future a dollar will be received, the less it is worth today. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 29. If you had a choice of choosing a payment of $5,000 to be received in five years being discounted at 8 percent or at 10 percent, you should always choose the higher rate because it gives you the higher present value. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 30. Future value focuses on the valuation of cash flows received over time, while present value focuses only on the valuation of cash flows received at a point in time. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 31. The present value factor 1 / (1 + i)n is the reciprocal of the future value factor (1 + i)n. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 32. The Rule of 72 allows one to calculate the return earned on an investment over six years. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 33. The Rule of 72 allows one to calculate the approximate time needed to double an investment. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 34. Compound growth occurs when the initial value of a number increases or decreases each period by the factor (1 + growth rate). A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 35. The compound annual growth rate (CAGR) is the average annual growth rate over a specified period of time. A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 36. The time value of money refers to the issue of: A) what the value of the stream of future cash flows is today. B) why a dollar received tomorrow is worth more than a dollar received today. C) what the time required to double an amount of money. D) why people prefer to consume things at some time in the future rather than today. Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 37. Which of the following statements is true of the time value of money? A) It means a dollar received today is worth less than a dollar received tomorrow. B) It assumes that inflation rate remains constant for the foreseeable future. C) It refers to the fact that higher cash flows in earlier years are less desirable. D) It is based on the assumption that people prefer to consume things at some time in the future rather than today. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 38. Which of the following statements is true? A) The value of a dollar invested at a positive interest rate decreases over time. B) The further in the future you receive a dollar, the less it is worth today. C) A dollar in hand today is worth less than a dollar to be received in the future. D) The higher the rate of interest, the more likely an investor will elect to consume at present and forgo invest his funds. Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 39. Which of the following statements is true of time value of money? A) A dollar received today is worth more than a dollar to be received in the future because future dollars are not affected by inflation. B) A dollar received today is worth less than a dollar to be received in the future because future dollars are not affected by inflation. C) A dollar received today is worth more than a dollar to be received in the future because funds received today can be invested to earn a return. D) A dollar to be received in the future is worth more than a dollar received today because it would have less risk associated with it. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 40. Future value measures: A) what one or more cash flows are worth at the end of a specified period. B) what one or more cash flows that is to be received in the future will be worth today. C) the value of an investment after subtracting interest earned on it for one or more periods. D) the value of an investment’s worth today. Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 41. Which of the following equations is used to compute the future value for continuous compounding? A) FV∞ = PV × e i × n B) FV∞ = PV ÷ e i × n C) FV∞ = ei ÷ PV D) FV∞ = ei × PV Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 42. The process of converting an amount given at the present time into a future value is called: A) annualizing. B) discounting. C) compounding. D) capital budgeting. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 43. Which of the following is true of the future value of an investment? A) The higher the interest rate, the higher the future value of an investment. B) The higher the inflation rate, the lower the future value of an investment. C) The lower the number of compounding periods, the higher the future value of an investment. D) The lower the present value of an investment, the higher the future value of an investment. Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 44. Which of the following investments will have the highest future value? A) $1,300 invested at an annual interest rate of 10% for 5 years B) $1,000 invested at an quarterly interest rate of 2.25% for 10 years C) $1,300 invested at an quarterly interest rate of 2.25% for 5 years D) $1,000 invested at an annual interest rate of 10% for 10 years Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 45. Which of the following statements is true? A) The longer the time period that funds are invested, the greater the future value. B) The lower the discount rate that funds are invested at, the greater the future value. C) The shorter the time period that funds are invested, the greater the future value. D) The higher the interest rate, the slower the value of an investment will grow. Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 46. Joseph Ray just received an inheritance of $35,775 from his great aunt. He plans to invest the funds for retirement. If Joseph can earn 4.75% per year with quarterly compounding for 32 years, how much will he have accumulated? (Round off to the nearest dollar.) A) $237,416 B) $71,550 C) $184,622 D) $162,113 Ans: D Feedback: Amount invested today = PV = $35,775 Frequency of compounding = m = 4 Interest rate = i = 4.75% ÷ 4 = 1.1875% Duration of investment = n = 32 years × 4 = 128 periods Value of investment after 7 years, or 128 periods = FV128 = $162,113.25 mn

i    0.0475  FV32 = PV   1 +  = $35,775   1 +  4   m  = $35,775  (1.011875)128 = $35,775  4.531467 = $162,113.25

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 47. Your aunt is looking to invest a certain amount today. Which of the following choices will give the maximum interest? A) Three-year CD at 6.5% annual rate B) Three-year CD at 6.75% annual rate C) Three-year CD at 6.25% annual rate D) Three-year CD at 7% annual rate Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 48. You are interested in investing $15,000, a gift from your grandparents, for the next four years in a mutual fund that will earn an annual return of 8 percent. What will your investment be worth at the end of four years? (Round to the nearest dollar.) A) $18,816 B) $20,407 C) $20,221 D) $18,089 Ans: B Feedback: Present value of the investment = PV = $15,000 Return on mutual fund = i = 8% No. of years = n = 4 0 1 2 3 4 ├───┼───┼───┼────┤ −$15,000 FV=? FV4 = PV × (1 + i)n = $15,000 × (1.08)4 = $20,407.33

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 49. Juan Vinson is planning to buy a house in five years. He is looking to invest $25,000 today in an index mutual fund that will provide him a return of 12 percent annually. How much will he have at the end of five years? (Round to the nearest dollar.) A) $45,000 B) $28,000 C) $44,059 D) $28,530 Ans: C Feedback: Present value of the investment = PV = $25,000 Return on mutual fund = i = 12% No. of years = n = 5 0 1 2 3 4 5 ├───┼───┼───┼────┼───┤ –$25,000 FV = ? FV5 = PV × (1 + i)n = $25,000 × (1.12)5 = $44,058.54

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 50. Carlos Lopes is looking to invest for the next three years. He is looking to invest $7,500 today in a bank CD that will earn interest at 5.75 percent annually. How much will he have at the end of three years? (Round to the nearest dollar.) A) $8,870 B) $8,575 C) $8,681 D) $8,990 Ans: A Feedback: Present value of the investment = PV = $7,500 Interest rate on CD = i = 5.75% No. of years = n = 3 0 1 2 3 ├───┼───┼───┤ –$7,500

FV=?

FV3 = PV  (1 + i )n = $7,500  (1.0.0575)3 = $8,869.57

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 51. Kevin Robertson would like to buy a condo in Florida in six years. He is looking to invest $75,000 today in a stock that is expected to earn a return of 18.3 percent annually. How much will he have at the end of six years? (Round to the nearest dollar.) A) $205,575 B) $157,350 C) $184,681 D) $273,620 Ans: A Feedback: Present value of the investment = PV = $75,000 Return on stock = i = 18.3% No. of years = n = 6 0 1 2 3 4 5 6 ├───┼───┼────┼───┼───┼───┤ –$75,000 FV=?

FV6 = PV  (1 + i )n = $75,000  (1.183)6 = $205, 574.73

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 52. Lori Willis plans to invest for retirement, which she hopes will be in 20 years. She is planning to invest $25,000 today in U.S. Treasury bonds that will earn interest at 6.25 percent annually. How much will she have at the end of 20 years? (Round to the nearest dollar.) A) $68,870 B) $50,625 C) $84,046 D) $75,000 Ans: C Feedback: Present value of the investment = PV = $25,000 Return on Treasury bonds = i = 6.25% No. of years = n = 20 0 1 2 3 19 20 ├───┼───┼───┼……………─┼────┤ –$25,000 FV=? FV20 = PV × (1 + i)n = $25,000 × (1.0625)20 = $84,046.34

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 53. Your brother has asked you to help him to choose an investment. He has $6,000 to invest today for a period of two years. You identify a bank CD that pays an interest rate of 4.25 percent with the interest being paid quarterly. What will be the value of the investment in two years? A) $6,550 B) $6,529 C) $6,107 D) $6,216 Ans: B Feedback: 0 2 years ├────────────────────┤ PV = $5,000 FV = ? Amount invested today = PV = $6,000 Interest rate on CD = i = 4.25% Duration of investment = n = 2 years Frequency of compounding = m = 4 Value of investment after 4 years = FV4 FV2 = PV × (1 + i/m)mn = $6,000 × (1 + (0.0425/4))2×4 = $6,529.37

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 54. Dynoxo Textiles has a cash inflow of $1 million, which it needs for a long-term investment, at the end of one year. It plans to deposit the money in a bank CD that pays daily interest at 4.50 percent. What will be the value of the investment at the end of the year? (Round to the nearest dollar.) A) $1,020,475 B) $1,000,103 C) $1,037,500 D) $1,046,025 Ans: D Feedback: 0 1 ├────────────────────┤ PV = $1,000,000 FV = ? Amount invested today = PV = $1,000,000 Interest rate on CD = i = 4.50% Duration of investment = n = 1 year Frequency of compounding = m = 365 Value of investment after 1 year = FV1 FV1 = PV × (1 + i/m)mn = $1,000,000 × (1 + (0.0450/365))365×1 = $1,046,024.96

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 55. Your mother is trying to choose one of the following bank CDs to deposit $10,000. Which will have the highest future value if she plans to invest for three years? A) 3.50% compounded daily B) 3.25% compounded monthly C) 3.40% compounded quarterly D) 3.75% compounded annually Ans: D Feedback:

A) Interest rate on CD = i = 3.50% Frequency of compounding = m = 365 Value of investment after 3 years = FV3 FV3 = PV × (1+ i/m)m×n = $10,000 × (1+ 0.035/365)365×3 = $10,000 × (1.00009589)1,095 = $11,107.05 B) Interest rate on CD = i = 3.25% Frequency of compounding = m = 12 Value of investment after 3 years = FV3 FV3 = PV × (1+ i/m)m×n = $10,000 × (1+ 0.0325/12)12×3 = $10,000 × (1.0027908333)36 = $11,022.66 C) Interest rate on CD = i = 3.40% Frequency of compounding = m = 4 Value of investment after 3 years = FV3 FV3 = PV × (1+ i/m)m×n = $10,000 × (1+ 0.034/4)4×3 = $10,000 × (1.0085)12 = $11,069.06 D) Interest rate on CD = i = 3.75% Frequency of compounding = m = 1 Value of investment after 3 years = FV3

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FV3 = PV × (1+ i/m)m×n = $10,000 × (1+ 0.0375) = $10,000 × (1.0375)3 = $11,167.71

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 56. Lorene Buckley wants to invest $3,500 today in a money market fund that pays a quarterly interest at 5 percent. She plans to fund a scholarship with the proceeds at her alma mater, Towson University. How much will Lorene have at the end of seven years? (Round to the nearest dollar.) A) $5,091 B) $3,849 C) $4,956 D) $5,075 Ans: C Feedback:

Amount invested today = PV = $3,500 Interest rate on money market account = i = 5% Duration of investment = n = 7 years Frequency of compounding = m = 4 Value of investment after 7 years = FV7 FV7 = PV × (1+ i/m)m×n = $3,500 × (1+0.05 / 4)4×7 = $3,500 × (1.0125)28 = $4,955.97

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 57. Paul Springer plans to save for a down payment for a house in 10 years. He will be able to invest $12,000 today in a money market account that will pay him an interest of 5.50 percent on a monthly basis. How much will he have at the end of 10 years? A) $12,640 B) $20,773 C) $24,859 D) $23,080 Ans: B Feedback:

Amount invested today = PV = $12,000 Interest rate on money market account = i = 5.50% Duration of investment = n = 10 years Frequency of compounding = m = 12 Value of investment after 10 years = FV10 FV10 = PV × (1+ i/m)m×n = $12,000 × (1+0.0550/4)12×10 = $12,000 × (1.04583)120 = $20,772.92

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 58. Jack Palomo has deposited $2,500 today in an account paying 6 percent interest annually. What would be the simple interest earned on this investment in five years? If the account paid compound interest, what would be the interest on interest in five years? A) $750; $95.56 B) $150; $845.56 C) $150; $95.56 D) $95.56; $845.56 Ans: A Feedback: Deposit today = PV = $2,500 Interest rate = i = 6% No. of years = n = 5 Simple interest: Simple interest per year = $2,500 × (0.06) = $150.00 Simple interest for 5 years = $150 × 5 = $750.00 Future value with compound interest: FV5 = $2,500 (1 + 0.06)5 = $3,345.56 Simple interest = $750 Interest on interest = $3,345.56 – $2,500 – $750 = $95.56

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 59. Camille Noah is investing $5,000 in an account paying 6.75 percent annually for three years. What is the interest on interest if interest is compounded? A) $1,012.50 B) $1,082.38 C) $82.38 D) $69.88 Ans: D Feedback: Deposit today = PV = $5,000 Interest rate = i = 6.75% No. of years = n = 3 Simple interest: Simple interest per year = $5,000 × (0.0675) = $337.50 Simple interest for 3 years = $337.50 × 3 = $1,012.50 Future value with compound interest: FV3 = $5,000 (1 + 0.0675)3 = $6,082.38 Simple interest = $1,012.50 Interest on interest = $6,082.38 – $5,000 – $1,012.50 = $69.88

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 60. Richard McLean wants to invest $3,000 in an account paying 5.25 percent compounded quarterly. What is the interest on interest after four years? A) $695.98 B) $65.98 C) $630.00 D) $157.50 Ans: B Feedback: Deposit today = PV = $3,000 Interest rate = i = 5.25% No. of years = n = 4 Frequency of compounding = m = 4 Simple interest: Simple interest per year = $3,000 (0.0525) = $157.50 Simple interest for 4 years = $157.50 × 4 = $630 Future value with compound interest: mn

i    0.0525  FV4 = PV   1 +  = $3,000   1 +  4   m  = $3,000  (1.013125)16 = $3, 695.98

44

Simple interest = $630 Interest on interest = $3,695.98 – $3,000 – $630 = $65.98

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 61. Dat Nguyen is depositing $17,500 in an account paying an annual interest rate of 8.25 percent compounded monthly. What is the interest on interest after six years? A) $8,662.50 B) $10,925.44 C) $2,497.63 D) $1,092.48 Ans: C Feedback: Deposit today = PV = $17,500 Interest rate = i = 8.25% No. of years = n = 6 Frequency of compounding = m = 2 Simple interest: Simple interest per year = $17,500 (0.0825) = $1,443.75 Simple interest for 6 years = $1,443.75 × 6 = $8,662.50 Future value with compound interest: mn

126

i    0.0825  FV6 = PV   1 +  = $17,500   1 +  12   m  = $17,500  (1.006875)72 = $28, 660.13

Simple interest = $8,662.50 Interest on interest = $28,660.13 – $17,500 – $8,662.50 = $2,497.63

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 62. Shawn Bowker invested $10,000 in a money market account that will pay 5.75 percent compounded daily. How much will the interest on interest be after two years? A) $1,218.63 B) $1,150.00 C) $33.06 D) $68.63 Ans: D Feedback: Deposit today = PV = $10,000 Interest rate = i = 5.75% No. of years = n = 2 Frequency of compounding = m = 365 Simple interest: Simple interest per year = $10,000 (0.0575) = $575 Simple interest for 2 years = $575 × 2 = $1,150 Future value with compound interest: mn

i    0.0575  FV2 = PV   1 +  = $10,000   1 +  365   m  = $10,000  (1.000157534)730 = $11, 218.63

3652

Simple interest = $575 Interest on interest = $11,218.63 – $10,000 – $1,150 = $68.63

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 63. Which of the following equations is used to calculate the future value of an investment? A) FVn = PV ÷ (1 + i)n B) FVn = PV × (1 + i)n C) FVn = (1 + i)n + PV D) FVn = (1 + i)n ÷ PV

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Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 64. Which of the following equations is used to calculate the future value of an investment when interest is compounded m times a year? A) FVn = PV ÷ (1 + i)m×n B) FVn = PV × (1 + i/m)m×n C) FVn = (1 + i)m×n+ PV D) FVn = (1 + i)m×n÷ PV Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 65. Joseph Harris is considering an investment that pays 6.5 percent annually. How much must he invest today such that he will have $25,000 in seven years? (Round to the nearest dollar.) A) $17,474 B) $18,850 C) $16,625 D) $16,088 Ans: D Feedback: 0 7 years ├────────────────────┤ PV = ? i = 6.5% FV = $25,000 Value of investment after 7 years = FV7 = $25,000 Return expected from investment = i = 6.5% Duration of investment = n = 7 years Amount to be invested today = PV

PV =

FVn $25,000 = = $16, 087.66 n (1 + i ) (1.065)7

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 66. Which of the following statements is true? A) Present value calculations involve converting the initial amount into a future amount. B) The present value (PV) is often called the compounded value of future cash payments. C) The present value is calculated by using the discount factor. D) The future value of an investment is the reciprocal of its present value. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 67. When discount rate: A) decreases, the present value of the future cash flow does not change. B) decreases, the present value of any future cash flow increases. C) increases, the present value of any future cash flow increases. D) increases, the present value of any future cash flow does not change. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 68. When discount rate: A) increases, the present value of a future cash flow decreases. B) increases, the present value of a future cash flow increases. C) decreases, the present value of a future cash flow will remain the same. D) decreases, the present value of a future cash flow decreases. Ans: A

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 69. Which of the following statements is true with respect to the present value of a future amount? A) The higher the discount rate, the higher the present value of a single sum for a given time period. B) The relation between present value and time is exponential. C) The greater the time period, the higher the present value of a single sum for a given interest rate. D) The lower the discount rate, the lower the present value of a single sum for a given time period. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 70. Juan and Rachel Burpo plan to buy a time-share in six years of $16,860. In order to have adequate funds to do so, the Burpo want to make a deposit to their money market fund today. Assume that they will be able to earn an investment rate of 5.75%, compounded annually. How much will Juan and Rachel need to deposit today to achieve their goal? (Round off to the nearest dollar.) A) $11,138 B) $8,885 C) $12,055 D) $14,243 Ans: C Feedback: Amount needed = FV = $16,860 Interest rate = i = 5.75% Duration of investment = n = 6 years Present Value = PV6 = $12,055.22

FV $16,860 = n (1 + i ) (1.0575)6 $16,860 = 1.398564 = $12, 055.22

PV6 =

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 71. Steve Fisher is saving for a new car. He needs to have $ 21,000 for the car in three years. How much will he have to invest today in an account paying 8 percent annually to achieve his target? (Round to nearest dollar.) A) $22,680 B) $26,454 C) $16,670 D) $19,444 Ans: C Feedback: 0 3 years ├────────────────────┤ PV = ? i = 8% FV = $21,000 Value of investment after 3 years = FV3 = $21,000 Return expected from investment = i = 8% Duration of investment = n = 3 years Amount to be invested today = PV

PV =

FVn $21,000 = = $16, 670.48 n (1 + i ) (1.08)3

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 72. Jacob’s friend, Albert, borrows today with a promise to repay $7,418.87 in four years. If Jacob could earn 5.45 percent annually on the any investment he makes today, how much would he be willing to lend Albert today? (Round to nearest dollar.) A) $6,000 B) $7,035 C) $6,500 D) $7,150 Ans: A Feedback: 0 4 years ├────────────────────┤ PV = ? i = 5.45% FV = $7,418.87 Loan repayment amount after 4 years = FV4 = $7,418.87 Return expected from loan = i = 5.45% Duration of loan = n = 4 years Amount to be loaned today = PV

PV =

FVn $7,418.87 = = $6, 000 n (1 + i ) (1.0545)4

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 73. Joyce Thomas wants to buy a house in six years. She hopes to have $25,000 at that time. If the bank CD she wants to invest in will pay 7.5 percent annually, how much will she have to invest today? (Round to the nearest dollar.) A) $18,472 B) $13,987 C) $16,199 D) $23,256 Ans: C Feedback: 0 6 years ├────────────────────┤ PV = ? i = 7.5% FV = $25,000 Amount needed for down payment after 6 years = FV6 = $25,000 Return expected from investment = i = 7.5% Duration of investment = n = 6 years Amount to be invested today = PV

PV =

FVn

(1 + i )

$25,000 = $16,199 (1.075)6

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 74. Robert Kelly wants to start a business in 10 years. He hopes to have $100,000 at that time to invest in the business. To reach his goal, he plans to invest a certain amount today in a bank CD that will pay him 9.50 percent annually. How much will he have to invest today to achieve his target? (Round to the nearest dollar.) A) $54,233 B) $63,837 C) $91,324 D) $40,351 Ans: D Feedback: 0 10 years ├────────────────────┤ PV = ? i = 9.5% FV = $100,000 Value of investment after 10 years = FV10 = $100,000 Return expected from investment = i = 9.5% Duration of investment = n = 10 years Amount to be invested today = PV

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 75. Leroy Diaz plans to invest some money today so that he will receive $7,500 in three years. If the investment he is considering will pay 3.65 percent compounded daily, how much will he have to invest today? A) $5,276 B) $6,722 C) $6,897 D) $7,140 Ans: B Feedback: 0 3 years ├────────────────────┤ PV = ? i = 3.65% FV = $7,500 Return expected from investment = i = 3.65% Duration of investment = n = 3 years Frequency of compounding = m = 365 Target investment proceeds in 3 years = FV3 = $7,500 Present value of amount = PV

PV =

FV3 mn

i   1 +   m = $6, 722.15

$7,500  0.0365  1 +  365  

3653

$7,500 (1.0001)1095

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 76. You need to have $15,000 in five years to payoff a home equity loan. You can invest in an account that pays 5.75 percent compounded quarterly. How much will you have to invest today to attain your target in five years? (Round to the nearest dollar.) A) $4,903 B) $11,275 C) $13,184 D) $12,250 Ans: B Feedback: 0 5 years ├────────────────────┤ PV = ? i = 5.75% FV = $15,000 Return expected from investment = i = 5.75% Duration of investment = n = 5 years Frequency of compounding = m = 4 Target investment proceeds in 5 years = FV5 = $15,000 Present Value of amount = PV

PV =

FVn mn

$15,000

i    0.0575  1 +  1 +  4   m  = $11, 275.10

54

$15,000 (1.014375)20

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 77. Tamera Watson is saving for her daughter's college education. She wants to have $50,000 available when her daughter graduates from high school in four years. If the investment she is considering will pay 8.25 percent compounded monthly, how much will she have to invest today to reach her target? (Round to the nearest dollar.) A) $35,987 B) $39,659 C) $41,275 D) $36,450 Ans: A Feedback: 0 4 years ├────────────────────┤ PV = ? i = 8.25% FV = $50,000 Return expected from investment = i = 8.25% Duration of investment = n = 4 years Frequency of compounding = m = 12 Target investment proceeds in 4 years = FV4 = $50,000 Present value of amount = PV

PV =

FV4 mn

$50,000 124

i    0.0825  1 +  1 +  12   m  = $35, 986.80

$50,000 (1.006875)48

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 78. Michael Peterson is seeking to accumulate $25,000 in six years to invest in a real estate venture. He can earn 6.35 percent annual interest with monthly compounding in a private investment. How much will he have to invest today to reach his goal? (Round to the nearest dollar.) A) $18,527 B) $23,015 C) $17,097 D) $19,648 Ans: C Feedback: 0 6 years ├────────────────────┤ PV = ? i = 6.35% FV = $25,000 Return expected from investment = i = 6.35% Duration of investment = n = 6 years Frequency of compounding = m = 12 Target investment proceeds in 6 years = FV6 = $25,000 Present value of amount = PV PV = FVn / (1+i/m)mn = $25,000 / (1+(0.005292/12))12×6 = $17,096.61

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 79. Celesta Frank wants to go on a cruise in three years. She could earn 8.2 percent compounded monthly in an account if she were to deposit the money today. She needs to have $10,000 in three years. How much will she have to deposit today? (Round to the nearest dollar.) A) $6,432 B) $7,826 C) $8,148 D) $7,763 Ans: B Feedback: 0 3 years ├────────────────────┤ PV = ? i = 8.2% FV = $10,000 Return expected from investment = i = 8.2% Duration of investment = n = 3 years Frequency of compounding = m = 12 Target investment proceeds in 3 years = FV3 = $10,000 Present value of amount = PV

PV =

FVn mn

i   1 +   m = $7, 825.77

$10,000 123

 0.082  1 +  12  

$10,000 (1.0068333)36

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 80. The process of converting future cash flows to what its present value is called: A) annualizing. B) discounting. C) compounding. D) capital budgeting. Ans B :

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 81. Which of the following equations is used to calculate the present value of a sum to be received in future? A) PV = FVn ÷ (1 + i)n B) PV = FVn × (1 + i)n C) PV = (1 + i)n + FVn D) PV = (1 + i)n ÷ FVn Ans A :

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 82. As per the rule of 72, the time to double your money (TDM) approximately equals: A) 72/n. B) 72/i. C) 72/Initial investment. D) 72/Future value. Ans B :

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 83. Which of the following statements is true of the rule of 72? A) It can be used to determine the amount of time it takes to double an investment. B) It is fairly accurate for interest rates between 25 and 50 percent. C) It states that the time to double your money (TDM) approximately equals 72/i, where i represents the years it takes to double your investment. D) It can be used to estimate approximate compound interest earned for a period of 72 days. Ans: A

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 84. Your tuition for the coming year is due today. You borrow $8,000 from your uncle and agree to repay in the three years an amount of $9,250. What is the interest rate on this loan? Round to the nearest percent. A) 5% B) 6% C) 7% D) 8% Ans: A Feedback: 0 3 years ├────────────────────┤ PV = $8,000 FV = $9,250 Amount to be borrowed = PV = $8,000 Amount to be paid back after 3 years = FV3 = $9,250 Interest rate on investment = i = ? Duration of investment = n = 3 years Present value of investment = PV

FVn (1 + i )n $9,250 $8,000 = (1 + i )3 $9,250 (1 + i )3 = = 1.15625 $8,000 PV =

(1 + i ) = (1.15625) 3 = 1.0496 i = 4.96%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 85. Anne Morgan wants to borrow $6,000 for a period of four years. She has two choices. Her bank is offering to lend her the amount at 7.25 percent compounded annually. She can also borrow from her firm and will have to repay a total of $8,130.93 at the end of four years. Should Anne go with her bank or the firm, and what is the interest rate if she borrows from her firm? (Round to the nearest percent.) A) She should borrow from the bank as the bank is charging a higher interest of 9%. B) She should borrow from her firm as it is charging a lower interest of 7%. C) She should borrow from the bank as the bank is charging a higher interest of 8%. D) She should borrow from her firm as it is charging a lower interest of 6%. Ans: C Feedback: 0 4 years ├────────────────────┤ PV = $6,000 FV = $8,130.93 Amount to be borrowed = PV = $6,000 Amount to be paid back after 4 years = FV = $8,130.93 Interest rate on investment = i = ? Duration of investment = n = 4 years Present value of investment = PV

FVn (1 + i )n $8,130.93 $6,000 = (1 + i )4 $8,130.93 (1 + i )4 = = 1.355155 $6,000 PV =

(1 + i ) = (1.355155) 4 = 1.07894 i = 7.89% Since borrowing from her firm results in a loan rate of 8 percent, she should take the bank loan at 7.25 percent.

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 86. Patrick Smith has $5,000 to invest in a small business venture. His partner has promised to pay him back $8,200 in five years. What is the return earned on this investment? A) 9.3% B) 8.7% C) 11.1% D) 10.4% Ans: D Feedback: 0 5 years ├────────────────────┤ PV = $5,000 FV = $8,200 Amount being invested = PV = $5,000 Amount to be paid back after 5 years = FV = $8,200 Interest rate on investment = i = ? Duration of investment = n = 5 years Present value of investment = PV

FVn (1 + i )n $8,200 $5,000 = (1 + i )5 $8,200 (1 + i )5 = = 1.6400 $5,000 PV =

(1 + i ) = (1.6400) 5 = 1.103999 i = 10.4%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 87. Winston Baker wants to invest $25,000 in a spa that his sister is starting. He will triple his investment in six years. What is the rate of return that Winston is being promised? (Rounded to the nearest percent.) A) 18% B) 20% C) 12% D) 25% Ans: B Feedback: 0 6 years ├────────────────────┤ PV = $25,000 FV = $75,000 Amount being invested = PV = $25,000 Amount to be paid back after 6 years = FV = $75,000 Interest rate on investment = i = ? Duration of investment = n = 6 years Present value of investment = PV

FVn (1 + i )n $75,000 $25,000 = (1 + i )6 $75,000 (1 + i )6 = = 3.0000 $25,000 PV =

(1 + i ) = (3.0000) 6 = 1.200937 i = 20%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 88. Michael Harper has $3,000 to invest for three years. He wants to receive $5,000 at the end of the three years. What invest rate would his investment have to earn to achieve his goal? (Round to the nearest percent.) A) 19% B) 21% C) 13% D) 16% Ans: A Feedback: 0 3 years ├────────────────────┤ PV = $3,000 FV = $5,000 Amount being invested = PV = $3,000 Amount to be paid back after 3 years = FV = $5,000 Interest rate on investment = i = ? Duration of investment = n = 3 years Present value of investment = PV

FVn (1 + i )n $5,000 $3,000 = (1 + i )3 $5,000 (1 + i )3 = = 1.66667 $3,000 PV =

(1 + i ) = (1.6667) 3 = 1.1856 i = 18.6%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 89. Finor Traps manufactures an innovative mouse trap. Total sales for the current year is $325,000. The company expects its sales to go up to $500,000 in five years. What is the expected growth rate in sales for this firm? (Round to the nearest percent.) A) 9% B) 11% C) 6% D) 12% Ans: A Feedback: 0 5 years ├────────────────────┤ PV = $325,000 FV = $500,000 Current sales = PV = $325,000 Expected sales five years from now = $500,000 To calculate the expected sales growth rate, we set up the future value equation.

FV5 = PV  (1 + g )5 $500,000 = $325,000(1 + g )5 $500,000 (1 + g )5 = = 1.538461538 $325,000 1

g = (1.538461538) 5 − 1 = 8.99%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 90. Bovic Inc. is a growing company with sales of $1.25 million this year. The company expects to grow at an annual rate of 25 percent for the next three years, followed by a growth of 20 percent per year for the next two years. What will be Bovic’s sales at the end of five years? (Round to the nearest percent.) A) $2,160,000 B) $3,515,625 C) $1,875,000 D) $2,929,688 Ans: B Feedback: 0 5 years ├────────────────────┤ g1-3 = 25% g4-5 = 20% PV = $1.25 million FV = ? Current sales = PV = $1,250,000 Expected sales five years from now = FV To calculate the expected sales, we set up the future value equation. FV5 = PV × (1+g1)3(1+g2)2 = ($1,250,000)(1.25)3(1.20)2 = $3,515,625

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 91. Manufic, a detergent manufacturer, has announced this year's net income as $832,500. It expects its net earnings to grow at a rate of 15 percent per year for the next two years, before dropping to 12 percent for each of the following two years. What is the firm's net income after four years? (Round to the nearest dollar.) A) $1,381,071 B) $1,266,128 C) $1,233,099 D) $1,072,260 Ans: A Feedback: 0 4 years ├────────────────────┤ g1-2 = 15% g3-4 = 12% PV = $832,500 FV = ? Current net income = PV = $832,500 Expected net income four years from now = FV To calculate the expected net earnings, we set up the future value equation.

FV4 = PV  (1 + g1 )2 (1 + g 2 )2 = $832,500(1.15)2 (1.12) 2 = $1, 381,070.88

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 92. Genor Peterson Electrical Supplies has generated a net income of $161,424 this year. The firm expects to see an annual growth of 30 percent for the next five years, followed by a growth rate of 15 percent for each of the next three years. What will be the firm's expected net income in eight years? (Round to the nearest dollar.) A) $319,157 B) $241,329 C) $911,546 D) $689,259 Ans: C Feedback: 0 5 8 years ├────────────────┼────────────┤ g1-5 = 30% g6-8 = 15% PV = $161,424 FV = ? Current net income = PV = $161,424 Expected net income four years from now = FV To calculate the expected net earnings, we set up the future value equation.

FV8 = PV  (1 + g1 )5 (1 + g 2 )3 = $161,424(1.30)5 (1.15)3 = $911,545.58

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 93. Locil Agencies is a fast-growing advertising agency. Currently, its sales is at $700,000. The company expects its sales to grow at an annual rate of 35 percent in the next two years, followed by an annual rate of 25 percent in years 3 through 7. Finally, its growth rate would slow down to 10 percent in years 8–10. What will be its sales as of year 10? (Round to the nearest dollar.) A) $1,698,023 B) $2,843,323 C) $3,893,280 D) $5,181,956 Ans: D Feedback: 0 5 10 years ├────────────────┼──────────────────┤ g1-2 = 35% g3-7 = 25% g8-10 = 10% PV = $700,000 FV = ? Current sales = PV = $700,000 Expected sales 10 years from now = FV To calculate the expected sales, we set up the future value equation.

FV10 = PV  (1 + g1 )2 (1 + g 2 )5 (1 + g3 )3 = $700,000(1.35)2 (1.25)5 (1.10)3 = $5,181,955.72

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 94. Your uncle is looking to double his investment of $10,000. He claims he can get earn 14 percent on his investment. How long will it take to double his investment? Use the Rule of 72 and round to the nearest year. A) 5 years B) 14 years C) 10 years D) 7 years Ans: A Feedback: Initial investment = $10,000 Rate of return on investment = i = 14% Time to double the investment = TDM = 72/i = 72 / 14 = 5.14 years

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 95. Animist Designers has generated sales of $625,000 for the current year. If it can grow the sales at a rate of 12 percent every year, how long will it take to triple the sales? (Round off to the nearest year.) A) 8 years B) 7 years C) 10 years D) 9 years Ans: C Feedback: By entering the following data into a financial calculator, the required number of years can be calculated as 9.69. 12 0 –$625,000 $1,875,000 N i PMT PV FV

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 96. Transent Foods announced that its current sales is $1,233,450 this year. The company forecasts a growth rate of 16 percent for the foreseeable future. How long will it take the firm to produce earnings of $3 million? (Round off to the nearest year.) A) 7 years B) 6 years C) 8 years D) 10 years Ans: B Feedback: By entering the following data into a financial calculator, the required number of years can be calculated as 5.99. 16 0 –$1,233,450 $3,000,000 N i PMT PV FV

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 98. Nickole wants to invest in a bank CD that will pay her 7.8 percent annually. If she invests $11,500 today, when will she reach her goal of $15,000? (Round off to the nearest year.) A) 5 years B) 7 years C) 2 years D) 4 years Ans: D Feedback: By entering the following data into a financial calculator, the required number of years can be calculated as 3.54.

7.8 i

0 PMT

–$11,500 PV

$15,000 FV

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 97. Albend Holmes wants to deposit $4,500 in a bank account that pays 8.25 percent annually. How many years will it take for his investment to grow to $10,000? (Round off to the nearest year.) A) 8 years B) 11 years C) 10 years D) 12 years Ans C : Feedback: By entering the following data into a financial calculator, the required number of years can be calculated as 10.07.

8.25 i

0 PMT

–$4,500 PV

$10,000 FV

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 99. Amanda Sorenson is planning her retirement. She is presently investing in a 401(k) but needs an additional $500,000 to reach her retirement goal. As luck would have it, Amanda just won a brand new car that is worth $36,000 in a raffle. If Amanda were to sell the car and invest the $36,000 proceeds at a rate of 6.50%, compounded annually, how long will it be before Amanda could retire? (Round off to the nearest 1/10 of a year) A) 36.6 years B) 41.8 years C) 52.2 years D) 24.0 years Ans B : Feedback: Present Value = PV = $36,000 Future Value = FV = $500,000 Interest rate = i = 6.50% Number of Periods = n = 41.8 years

FVn = PV (1 + i )n =

FVn = (1 + i )n PV

$500,000 = (1.065)n = 13.88889 = (1.065) n $36,000 nLN (1.065) = LN (13.88889) LN (13.888889) 2.631089 n= = = 41.78 years LN (1.065) .062975

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 100. Omniva Inc. just generated earnings per share of $3.75 for the fiscal year ending September 30, 2014. The firm is expected to achieve earnings per share of $8.76 in 5-years. At what rate will Omniva Inc.’s earnings per share be growing over this 5-year period? (Round off to the nearest 1/10 percent) A) 15.7% B) 18.5% C) 21.3% D) 13.4% Ans B : Feedback: Present Value = PV = $3.75 Period = n = 5 years Future Value = FV5 = $8.76 Interest rate = i = 18.49% 1

 FV  5 i=  −1  PV  1

 $8.76  5 =  −1  $3.75  1

= ( 2.336 ) 5 − 1 = 1.184935 − 1 = .184935 Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 101. Explain the difference between simple interest and compound interest. Ans: Simple interest refers to the interest earned on the initial investment over the investment period. Compound interest includes not only simple interest but also interest earned on the reinvestment of previously earned interest. Thus, compound interest includes both the simple interest and the interest on interest.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 102. Explain how the future and the present value equations are related. Ans: To get the future value (FVn) of funds invested for n years, we multiply the original investment by (1+ i)n. To find the present value of a future payment (PV), we divide FVn by (1 + i)n.

Format: Essay Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 103. Suppose you win $10 million in a lottery. You have a choice of how you will receive your winnings. The first choice is to receive a certain lump sum today. The second choice is to receive a certain amount at the end of five years. How will you evaluate your choices to make your decision? Ans: In order to make the correct choice, one has to make the comparison on the same basis. That is, you calculate the future value of the lump sum invested today at your opportunity cost and compare it to the future value under your second choice. Or you discount the future value of the amount in your second choice to its present value and compare it to the lump sum in your first choice. Either of the two approaches would allow you to select the choice that provides you the highest amount.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 104. Suppose that you just attended a lecture on Time Value of Money. On your way home, you stopped in to get a cup of coffee. One of your classmates, who missed the lecture, joined you for coffee and asked you to explain to her the key concepts of time value of money and how you could use it to solve some of practical financial problems. What would you tell her? Ans: Time value of money has to do with making decisions about investments; e.g., how much should one pay today for a share of common stock, for an apartment building, etc. This amount is known as the present value. The answer involves a number of important concepts: (1.) the expected/required rate of return; this is known as rate. (2.) The expected time that the investment will be held; this is known as number of periods. (3.) The expected cash flow(s); this is known as future value, or if a series of future values it is known as payments. (4) The frequency at which the rate is compounded or discounted; i.e., annually, quarterly, monthly, etc. The way in which these types of problems can be solved is by usage of mathematical formulas, financial calculators, or spreadsheet models.

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Fundamentals of Corporate Finance 3e

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Chapter 6: Discounted Cash Flows and Valuation Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 1. Calculating the present and future values of multiple cash flows is relevant only for individual investors. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 2. Calculating the present and future values of multiple cash flows is relevant for businesses only. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 3. In computing the present and future value of multiple cash flows, each cash flow is discounted or compounded at a same rate. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 4. The present value of multiple cash flows is greater than the sum of those cash flows. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 5. Jacob Oram pay the same amount every month as insurance premium for a term life policy for a period of five years, the stream of cash flows is called a perpetuity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 6. Allen Bell pay the same amount every month on a car loan for a period of three years, the stream of cash flows is called an annuity. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 7. In today's financial markets, the best example of a perpetuity is the common stock issued by firms. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 8. Since the issuers of preferred stock promise to pay investors a fixed dividend, usually quarterly, forever, these are the most important perpetuities in the financial markets. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 9. The present value of a perpetuity is the promised constant cash payment divided by the interest rate (i). A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 10. In ordinary annuities, cash flows occur at the beginning of each period. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 11. In an annuity due, cash flows occur at the beginning of each period. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 12. The lease payments by a business of a warehouse rental are an example of an annuity due. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2, LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 13. The present value of an annuity due is less than the present value of an ordinary annuity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2, LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 14. The present value of an annuity due is equal to the present value of an ordinary annuity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2, LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 15. The future value of an annuity due is greater than the future value of an ordinary annuity. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2, LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 16. The future value of an annuity due is equal to the future value of an ordinary annuity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 17. Cash flow streams that increase at a constant rate over time are called growing annuities or growing perpetuities. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 18. A fertilizer manufacturing company enters into a contract with a county parks and recreation department that calls for the company to sell 10 percent more of its best lawn feed every year for the next five years. If they also agree to maintain the total price as constant over the contract period, this growth in revenue is an example of a growing perpetuity. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 19. You have received news about an inheritance that will pay you $5,000 next year. Beginning the following year, your inheritance will increase by 5 percent every year forever. This is a growing perpetuity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 20. Natalia Greenberg opened a pizza place last year. She expects to increase her revenue from last year by 7 percent every year for the next 10 years. This is an example of a growing annuity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 21. The annual percentage rate (APR) is the annualized interest rate using compound interest. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 22. The annual percentage rate (APR) is defined as the simple interest charged per period multiplied by the number of periods per year. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 23. The correct way to annualize an interest rate is to compute the effective annual interest rate. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knkowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 24. The correct way to annualize an interest rate is to compute the annual percentage rate (APR). A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 25. The effective annual interest rate (EAR) is defined as the annual growth rate that takes compounding into account. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 26. The effective annual interest rate (EAR) is the true cost of borrowing and lending. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 27. The quoted interest rate is by convention a simple annual interest rate, such as the annual percentage rate (APR). A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 28. The quoted interest rate is by definition a simple annual interest rate, such as the effective annual interest rate (EAR). A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Legal/Regulatory Perspective 29. The Truth-in-Lending Act and the Truth-in-Savings Act require by law that the annual percentage rate (APR) be disclosed on all consumer loans and savings plans and that it be prominently displayed on advertising and contractual documents. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 30. Only the annual percentage rate (APR) or some other quoted rate should be used as the interest rate factor for present or future value calculations. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 31. A car manufacturer enters into a contract for 25-years lease of warehouse rental that adjusts annually for the expected rate of inflation over the life of the contract. This is an example of growing perpetuity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 32. A growing annuity for an infinite period is called a growing perpetuity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 33. For computation of the present value of growing annuity with n periods, the cash flow for the current period is used and not the cash flow to be received in the next period. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 34. Growing perpetuity is widely used in the valuation of common stock of firms that have a policy and history of paying dividends that grow at a constant rate. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 35. The present value of growing perpetuity is computed as the cash flow occurring at the end of the first period divided by the difference between interest or discount rate and growth rate. A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance

AICPA: Measurement 36. Which of the following is used as the denominator while calculating the present value for a growing perpetuity that begins next period (PVP)? A) The difference between i (the discount or interest rate) and g (the constant rate of growth of the cash flow) B) i (the discount or interest rate) C) g (the constant rate of growth of the cash flow) D) The addition of i (the discount or interest rate) and g (the constant rate of growth of the cash flow) Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 37. The present value of future cash flows are computed by multiplying future value with the: A) discounting factor. B) compound factor. C) interest rate. D) number of periods. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 38. Nick invested $2,000 in a bank savings account today and another $2000 a year from now. If the bank pays interest of 10 percent per year, how much money will Nick have at the end of two years? A) $4,210 B) $4,200 C) $4,000 D) $4,620 Ans: D Feedback: Future value of two cash flows = [PV × (1 + i)2]+ [PV × (1 + i)] = [$2,000 × (1 + 0.10)2] + [$2,000 × (1 + 0.10)] = [$2,000 × (1.10)2] + [$2,000 × (1.10)] = [$2,000 × 1.21]+ [$2,000 × 1.10] = $2,420 + $2,200 = $4,620

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 39. Which of the following is true of discounting factor? A) Discounting factor is the reciprocal of compounding factor. B) Discounting factor is the sum of 1 and the rate of interest. C) Discounting factor is period n times the rate of interest. D) Discounting factor is computed by dividing period n by the sum of 1 and the rate of interest. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 40. William deposited $25,000 today that would earn an interest at the rate of 3% for a period of 2 years. The amount of $25,000 represents the: A) present value of an annuity B) future value of an annuity C) present value D) future value Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 41. In computing the present and future value of multiple cash flows: A) each cash flow is discounted or compounded at the same rate. B) each cash flow is discounted or compounded at a different rate. C) earlier cash flows are discounted at a higher rate. D) later cash flows are discounted at a higher rate. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 42. Anna would receive $15,000 from a bank deposit after 2 years which had an interest of 3.5%. The amount of $15,000 represents the: A) present value of an annuity B) future value of an annuity C) present value D) future value Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 43. The present value of multiple cash flows is: A) greater than the sum of the cash flows. B) equal to the sum of all the cash flows. C) less than the sum of the cash flows. D) higher or lower than the cash flows depending on the interest rate. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 44. The future value of multiple cash flows is: A) greater than the sum of the cash flows. B) equal to the sum of all the cash flows. C) less than the sum of the cash flows. D) higher or lower than the cash flows depending on the interest rate. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 45. If your investment pays the same amount at the end of each year for a period of six years, the cash flow stream is called: A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) a growing perpetuity. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 46. If your investment pays the same amount at the beginning of each year for a period of 10 years, the cash flow stream is called: A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) a growing perpetuity. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comrpehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 47. A preferred stock would be an ideal example of: A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) a growing annuity. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 48. Cash flows associated with annuities are considered to be: A) an uneven cash flow stream. B) a constant cash flow stream. C) a mix of constant and uneven cash flow streams. D) a cash flow stream with decreasing trend. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 49. Which of the following statements is true of amortization? A) Amortization solely refers to the total value to be paid by the borrower at the end of maturity. B) The amortization schedule represents only the interest portion of the loan. C) The computation of loan amortization is wholly based on the computation of simple interest. D) The amortization schedule provides the data of equated monthly payments for which the classification of principal and interest along with unpaid principal balance is provided. Ans: D

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 50. Which of the following statements is true of amortization? A) With an amortized loan, a periodical payment of principal portion gradually decreases over a period. B) Amortization schedule represents only the interest portion of the loan. C) With an amortized loan, a bigger proportion of each month's payment goes toward interest in the early periods. D) The computation of loan amortization is wholly based on the computation of simple interest. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 51. Which of the following statements is true of amortization? A) With an amortized loan, a bigger proportion of each month's payment goes toward interest in the early periods. B) With an amortized loan, a bigger proportion of each month's payment goes toward interest in the later periods. C) With an amortized loan, a smaller proportion of each month's payment goes toward interest in the early periods. D) With an amortized loan, the interest portion of each month’s payment remains unchanged. Ans: A

6-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 52. The annuity transformation method is used to transform: A) a present value annuity to a future value annuity. B) a present value annuity to an annuity due. C) an ordinary annuity to an annuity due. D) a perpetuity to an annuity. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 53. A firm receives a cash flow from an investment that will increase by 10 percent annually for an infinite number of years. This cash flow stream is called: A) an annuity due. B) a growing perpetuity. C) an ordinary annuity. D) a growing annuity. Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 54. Your investment in a small business venture will produce cash flows that increase by 15 percent every year for the next 25 years. This cash flow stream is called: A) an annuity due. B) a growing perpetuity. C) an ordinary annuity. D) a growing annuity. Ans: D

6-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 55. Which of the following statements is true about the effective annual rate (EAR)? A) The effective annual interest rate (EAR) is defined as the annual growth rates that do not take compounding into account. B) The EAR is the annualized interest rate using simple interest. It ignores the interest earned on interest associated with compounding periods of less than one year. C) The EAR is the simple interest charged per period multiplied by the number of periods per year. D) The EAR is the interest rate actually paid (or earned) after accounting for compounding. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 56. The true cost of borrowing is the: A) annual percentage rate. B) effective annual rate. C) quoted interest rate. D) periodic rate. Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 57. The true cost of lending is the: A) annual percentage rate. B) effective annual rate. C) quoted interest rate. D) interest rate per period. Ans: B

6-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 58. Which of the following statements is true of annual percentage rate (APR)? A) The APR is similar to quoted interest rate which is a simple annual rate. B) The APR calculation adjusts for the effects of compounding and, hence, the time value of money. C) The APR is the true cost of borrowing and lending. D) The APR takes compounding into account. Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 59. Which of the following statements is true of annual percentage rate (APR)? A) The Truth-in-Savings Act was passed by Congress to ensure that the true cost of credit was disclosed to consumers. B) The Truth-in-Lending Act was passed to provide consumers an accurate estimate of the return they would earn on an investment. C) The Truth-in-Savings Act and Truth-in-Lending Act require by law that the APR be disclosed on all consumer loans and savings plans. D) The annual percentage rate (APR), and not the effective annual interest rate (EAR), represents the true economic interest rate. Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 60. What is the appropriate interest rate to use when making future or present value calculations? A) The effective annual interest rate (EAR) B) The annual percentage rate (APR) C) The quoted interest rate D) The simple interest Ans: A

6-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 61. Krysel Inc. is expecting a new project to start producing cash flows, beginning at the end of this year. They expect cash flows to be as follows: 1 $663,547

2 $698,214

3 $795,908

4 $798,326

5 $755,444

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

i = 9.20%

FV5= $663,547(1.092)4 + $698,214(1.092)3 + $795,908(1.092)2 + $798,326(1.092)1 + $755,444 = $943,544.19 + $909,193.80 + $949,091.64 + $871,771.99 + $755,444.00 = $4,429,045.62

6-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 62. Phosfranc Inc., is expecting the following cash flows starting at the end of the year—$133,245, $152,709, $161,554, and $200,760. If their opportunity cost is 9.4 percent, find the future value of these cash flows. (Round to the nearest dollar.) A) $734,731 B) $756,525 C) $734,231 D) $776,252 Ans: A Feedback: 0 1 2 3 4 ├─────────┼────────┼─────────┼────────┼ $133,245 $152,709 $161,554 $200,760 n=4

i = 9.40%

FV4= $133,245(1.094)3 + $152,709(1.094)2 + $161,554(1.094)1 + $200,760 = $174,462.82 + $182,767.63 + $176,740.08 + $200,760.00 = $734,730.53

6-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 63. Robert White will receive from his investment cash flows of $4,450, $4,775, and $5,125. If he can earn 7 percent on any investment that he makes, what is the future value of his investment cash flows at the end of three years? (Round to the nearest dollar.) A) $15,329 B) $15,427 C) $16,427 D) $14,427 Ans: A Feedback:

$4,450 n=4

$4,775

$5,125

i = 7.0%

FV3= $4,450(1.094)2 + $4,775(1.094)1 + $5,125 = $5,094.81 + $5,109.25 + $5,125.00 = $15,329.06

6-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 64. Scottie Barnes has invested in an investment that will pay him $6,400, $6,450, $7,225, and $7,500 over the next four years. If his opportunity cost is 10 percent, what is the future value of the cash flows he will receive? (Round to the nearest dollar.) A) $27,150 B) $32,020 C) $30,455 D) $31,770 Ans: D Feedback:

$6,400 n = 4;

$6,450

$7,225

$7,500

i = 10%

FV4 = $6,400(1.10)3 + $6,450(1.10)2 + $7,225(1.10)1 + $7,500 = $8,518.40 + $7,804.50 + $7,947.50 + $7,500 = $31,770.40

6-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 65. Global Shippers Inc. has forecast earnings of $1,233,600, $1,345,900, and $1,455,650 for the next three years. What is the future value of these earnings if the firm's opportunity cost is 13 percent? (Round to the nearest dollar.) A) $4,214,360 B) 4,551,701 C) $3,900,865 D) $4,362,428 Ans: B Feedback:

1,233,600

1,345,900

1,455,650

FV3 = $1,233,600(1.13)2 + 1,345,900(1.13)1 + $1,455,650 = 1,575,183.84 + $1,520,867.00 + $1,455,650.00 = $4,551,700.84

6-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 66. Damien McCoy has loaned money to his brother at an interest rate of 5.85 percent. He expects to receive $987, $1,012, $1,062, and $1,162 at the end of the next four years as complete repayment of the loan with interest. How much did he loan out to his brother? (Round to the nearest dollar.) A) $3,785 B) $3,757 C) $3,657 D) $3,685 Ans: C Feedback:

$987 n=4

$1,012

$1,062

$1,162

i = 5.85%

$987 $1,012 + + (1.0585) (1.0585)2

$1,062 3

(1.0585)

$1,162 (1.0585)4

= $932.45 + $903.23 + $895.47 + $925.64 = $3,656.80

6-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 67. Newship Inc. has borrowed from its bank at a rate of 8 percent and will repay the loan with interest over the next five years. Its scheduled payments, starting at the end of the year are as follows—$450,000, $560,000, $750,000, $875,000, and $1,000,000. What is the present value of these payments? (Round to the nearest dollar.) A) $2,735,200 B) $2,989,351 C) $2,431,224 D) $2,815,885 Ans: D Feedback:

$450, 000 $560, 000 $750, 000 $875, 000 $1, 000, 000 + + + + (1.08) (1.08) 2 (1.08)3 (1.08) 4 (1.08) 5 = $416, 666.67 + $480,109.74 + $595,374.18 + $643,151.12 + $680,583.20 = $2, 815, 884.91

PV =

6-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 68. David Stephens has made an investment that will pay him $11,455, $16,376, and $19,812 at the end of the next three years. His investment was to fetch him a return of 14 percent. What is the present value of these cash flows? (Round to the nearest dollar.) A) $37,712 B) $36,022 C) $41,675 D) $39,208 Ans: B Feedback:

$11, 455 $16,376 $19,812 + + (1.14) (1.14) 2 (1.14)3 = $10, 048.25 + $12, 600.80 + $13,372.54 = $36, 021.58

PV =

6-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 69. Nutech Corp. is expecting the following cash flows—$79,000, $112,000, $164,000, $84,000, and $242,000—over the next five years. If the company’s opportunity cost is 15 percent, what is the present value of these cash flows? (Round to the nearest dollar.) A) $429,560 B) $485,097 C) $480,906 D) $477,235 Ans: A Feedback:

$79, 000 $112, 000 $164, 000 $84, 000 $242, 000 + + + + (1.15) (1.15) 2 (1.15)3 (1.15) 4 (1.15)5 = $68, 695.65 + $84, 688.09 + $107,832.66 + $48, 027.27 + $120,316.77 = $429, 560.45

PV =

6-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 70. Helen Ashley is expecting cash flows of $50,000, $75,000, $125,000, and $250,000 from an inheritance over the next four years. If she can earn 11 percent on any investment that she makes, what is the present value of her inheritance? (Round to the nearest dollar.) A) $361,998 B) $414,454 C) $412,372 D) $434,599 Ans: A Feedback:

= $45,045.05 + $60,871.68 + $91,398.92 + $164,682.74 = $361,998.39

6-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 71. Ransport Company has made an investment in another company that will guarantee it a cash flow of $37,250 each year for the next five years. If the company uses a discount rate of 15 percent on its investments, what is the present value of this investment? (Round to the nearest dollar.) A) $101,766 B) $124,868 C) $251,154 D) $186,250 Ans: B Feedback:

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

1   1 −  (1 + i ) n  PVAn = PMT    i     1   1 − (1.15)5  = $37, 250    = $37, 250  3.3522  0.15    = $124, 867.78

6-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 72. Ryan Campbell has invested in a fund that will provide him a cash flow of $11,700 for the next 20 years. If his opportunity cost is 8.5 percent, what is the present value of this cash flow stream? (Round to the nearest dollar.) A) $234,000 B) $132,455 C) $110,721 D) $167,884 Ans: C Feedback:

1   1 − (1 + i) n  PVAn = PMT    i     1   1 − (1.085) 20  = $11, 700    = $11, 700  9.4633  0.085    = $110, 721.04

6-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 73. Moore’s Inc. will be making lease payments of $3,895.50 for a 10-year period, starting at the end of this year. If the firm uses a 9 percent discount rate, what is the present value of this annuity? (Round to the nearest dollar.) A) $23,250 B) $29,000 C) $25,000 D) $20,000 Ans: C Feedback:

1   1 − (1 + i) n  PVAn = PMT    i     1   1 − (1.09)10  = $3,895.50    = $3,895.50  6.4177  0.09    = $24, 999.99

6-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 74. Graciela Treadwell won a lottery. She will have a choice of receiving $25,000 at the end of each year for the next 30 years, or a lump sum today. If she can earn a return of 10 percent on any investment she makes, what is the minimum amount she should be willing to accept today as a lump-sum payment? (Round to the nearest hundred dollars.) A) $750,000 B) $334,600 C) $212,400 D) $235,700 Ans: D Feedback:

6-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 75. Insulor Inc. is expecting cash flows of $67,000 at the end of each year for the next five years. If the firm's discount rate is 17 percent, what is the present value of this annuity? (Round to the nearest dollar.) A) $214,356 B) $241,653 C) $278,900 D) $197,776 Ans: A Feedback:

6-36

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 76. Lloyd Harris is planning to invest $3,500 every year for the next six years in an investment paying 13 percent annually. What will be the amount he will have at the end of the six years? (Round to the nearest dollar.) A) $21,000 B) $29,129 C) $24,670 D) $26,124 Ans: B Feedback:

n = 6;

i = 13%

= $3,500 × (1.13)6 – 1 0.13 = $3,500 × 8.3227 = $29129.47

6-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 77. Shaun Barringer has started on his first job. He plans to start saving for retirement. He will invest $5,000 at the end of each year for the next 45 years in a fund that will earn a return of 10 percent. How much will Shaun have at the end of 45 years? (Round to the nearest dollar.) A) $2,667,904 B) $3,594,524 C) $1,745,600 D) $5,233,442 Ans: B Feedback:

6-38

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 78. John Mason decided to save $2,250 at the end of each of the next three years to pay for a vacation. If he invests it at 8 percent, how much will he have at the end of three years? (Round to the nearest dollar.) A) $7,304 B) $7,403 C) $6,297 D) $7,010 Ans: A Feedback:

$2,250 n=3

$2,250

i = 8.0%

= $2,250 × (1.08)3– 1 0.08 = $7,304.40 × 3.2464 = $7,304.40

6-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 79. Barbara Lakey is saving to buy a new car in four years. She will save $5,500 at the end of each of the next four years. If she invests her savings at 7.75 percent, how much will she have after four years? (Round to the nearest dollar.) A) $22,000 B) $23,345 C) $27,556 D) $28,692 Ans: D Feedback:

=$5,500 × (1.0775)4 – 1 0.0775 = $5,500 × 4.4895 = $24,692.25

6-40

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 80. Rosalia White will invest $3,000 in an IRA for the next 30 years starting at the end of this year. The investment will earn 13 percent annually. How much will she have at the end of 30 years? (Round to the nearest dollar.) A) $879,598 B) $912,334 C) $748,212 D) $1,233,450 Ans: A Feedback:

6-41

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 81. Viviana Carroll needs to have $25,000 in five years. If she can earn 8 percent on any investment, what is the amount that she will have to invest every year at the end of each year for the next five years? (Round to the nearest dollar.) A) $5,000 B) $4,261 C) $4,640 D) $4,445 Ans: B Feedback:

6-42

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 82. Cassandra Dawson wants to save for a trip to Australia. She will need $12,000 at the end of four years. She can invest a certain amount at the beginning of each of the next four years in a bank account that will pay her 6.8 percent annually. How much will she have to invest annually to reach her target? (Round to the nearest dollar.) A) $3,000 B) $2,980 C) $2,538 D) $2,711 Ans: C Feedback:

6-43

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 83. Dawson Electricals has borrowed $27,850 from its bank at an annual rate of 8.5 percent. It plans to repay the loan in eight equal installments, beginning at the end of next in a year. What is its annual loan payment? (Round to the nearest dollar.) A) $4,708 B) $5,134 C) $4,939 D) $4,748 Ans: C Feedback:

PVAn = $27,850

n = 8;

i = 8.5%

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

1   1 − (1 + i ) n  PVAn = PMT    i     $27,850 $27,850 PMT = = 1   5.6392 1 − (1.085)8     0.085    = $4, 938.66 Each payment made by Dawson Electricals will be $4,938.66, starting at the end of next year.

6-44

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 84. Tim Dodson has borrowed $8,600 to pay for his new car. The annual interest rate on the loan is 9.4 percent, and the loan needs to be repaid in four payments. What will be his annual payment if he begins his payment beginning now? (Round to the nearest dollar.) A) $2,229 B) $2,304 C) $2,850 D) $2,448 Ans: D Feedback:

PVAn = $8,600

n = 4;

i = 9.4%

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

PMT =

$8,600

$8,600 3.2115×1.094 = $2,447.80 Each payment made by Tim Dodson will be $2,447.80, starting today.

6-45

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 85. James Perkins wants to have a million dollars at retirement, which is 15 years away. He already has $200,000 in an IRA earning 8 percent annually. How much does he need to save each year, beginning at the end of this year to reach his target? Assume he could earn 8 percent on any investment he makes. (Round to the nearest dollar.) A) $13,464 B) $14,273 C) $10,900 D) $16,110 Ans: A Feedback: Retirement investment target in 15 years = $1,000,000 Amount invested in IRA account now = PV = $200,000 Return earned by investment = i = 8% Value of current investment in 15 years = FV15

FV15 = PV (1 + i )15 = $200, 000(1.08)15 = $634, 433.82 Balance of money needed to reach his target of having million dollars = $1,000,000 – $634,433.82 = $365,566.18 = FVA Payment needed to reach target = PMT

6-46

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 86. Stuart Weddle’s father is 55 years old and wants to set up a cash flow stream that would be forever. He would like to receive $15,000 every year, beginning at the end of this year. If he could invest in account earning 9 percent, how much would he have to invest today to receive his perpetual cash flow? (Round to the nearest dollar.) A) $166,667 B) $200,000 C) $222,222 D) $135,200 Ans: A Feedback: Annual payment needed = PMT = $15,000 Investment rate of return = i = 9% Term of payment = Perpetuity Present value of investment needed = PV

= $15,000 0.09 = $166,666.67

6-47

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 87. A lottery winner was given a perpetual payment of $25,362. She could invest the cash flows at 7.5 percent. What is the present value of this perpetuity? (Round to the nearest dollar.) A) $338,160 B) $390,215 C) $238,160 D) $201,356 Ans: A Feedback: Annual payment needed = PMT = $25,362 Investment rate of return = i = 7.5% Term of payment = Perpetuity Present value of investment needed = PV

= $25,362 0.075 = $338,160

6-48

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 88. Brandon Ramirez wants to set up a scholarship at his alma mater. He is willing to invest $320,000 in an account earning 11 percent. What will be the annual scholarship that can be given from this investment? (Round to the nearest dollar.) A) $50,000 B) $32,600 C) $35,200 D) $40,300 Ans: C Feedback: Annual payment needed = PMT Present value of investment = PVA = $320,000 Investment rate of return = i = 11% Term of payment = Perpetuity

PMT = = =

PV of Perpetuity × i $320,000 × 0.11 $35,200

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 89. Sid Phillips has funded a retirement investment with $250,000 earning a return of 6.75 percent. What is the value of the payment that he can receive in perpetuity? (Round to the nearest dollar.) A) $12,150 B) $15,250 C) $16,875 D) $14,900 Ans: C Feedback: Annual payment needed = PMT Present value of investment = PVA = $250,000 Investment rate of return = i = 6.75% Term of payment = Perpetuity

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Fundamentals of Corporate Finance 3e

Test Bank

= $250,000 × 0.0675 = $16,875

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 90. Ralf Wilson wants to receive $25,000 in perpetuity and will invest his money in an investment that will earn a return of 14 percent annually. What is the value of the investment that he needs to make today to receive his perpetual cash flow stream? (Round to the nearest dollar.) A) $640,225 B) $252,325 C) $144,350 D) $178,571 Ans: D Feedback: Annual Payment needed = PMT = $25,000 Investment rate of return = i = 14% Term of payment = Perpetuity Present value of investment needed = PV

= $25,000 0.14 = $178,571.43

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 91. You plan to save $1,400 for the next four years, beginning now, to pay for a vacation. If you can invest it at 6 percent, how much will you have at the end of four years? Round to the nearest dollar. A) $6,124 B) $5,618 C) $4,019 D) $6,492 Ans: D Feedback: 0 1 2 3 4 ├───────┼────────┼───────┼────────┤ $1,400 $1,400 $1,400 $1,400 n = 4; i = 6%

 (1 + i) n  FVA = PMT     (1 + i )  i   (1.06)4 − 1  = $1, 400     (1.06)  0.06  = $1, 400  4.3746 1.06 = $6, 491.93

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 92. Jeff Lovett has a five-year loan on which he will make annual payments of $2,235, beginning now. If the interest rate on the loan is 8.3 percent, what is the present value of this annuity? (Round to the nearest dollar.) A) $9,588 B) $8,854 C) $8,612 D) $9,122 Ans: A Feedback: 0 1 2 3 4 5 ├───────┼────────┼───────┼────────┼───────┤ $2,235 $2,235 $2,235 $2,235 $2,235 n = 5; i = 8.3% Annual payment = PMT = $2,235 No. of payments = n = 5 Required rate of return = 8.3% Present value of investment = PVA5

1   1 − (1 + i ) n  PVA = PMT     (1 + i ) i     1   1 − (1.083)5  = $2, 235     (1.083)  0.083    = $2, 235  3.9613 1.083 = $9, 588.44

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 93. : Ann Chang is investing $2,500 today and will do so at the beginning of each of the next six years for a total of seven payments. If her investment can earn 12 percent, how much will she have at the end of seven years? (Round to the nearest dollar.) A) $25,223 B) $28,249 C) $31,127 D) $29,460 Ans: B Feedback: 0 1 2 3 6 7 ├───────┼────────┼───────┼………………┼───────┤ PMT PMT PMT PMT PMT n = 7; i = 12% Present value of annuity = PVA Return on investment = i = 12% Payment required to meet target = $2,500 Type of annuity = Annuity due

 (1 + i) n  FVA = PMT     (1 + i )  i   (1.12)7 − 1  = $2,500     (1.12)  0.12  = $2,500 10.0890  1.12 = $28, 249.23

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 94. Your inheritance will pay you $100,000 a year for five years beginning now. You can invest it in a CD that will pay 7.75 percent annually. What is the present value of your inheritance? (Round to the nearest dollar.) A) $399,356 B) $401,916 C) $433,064 D) $467,812 Ans: C Feedback: 0 1 2 3 4 5 ├───────┼────────┼───────┼────────┼───────┤ $100,000 $100,000 $100,000 $100,000 $100,000 n = 5; i = 7.75% Annual payment = PMT = $100,000 No. of payments = n = 5 Required rate of return = 7.75% Present value of investment = PVA5

1   1 − (1 + i ) n  PVA = PMT     (1 + i ) i     1   1 − (1.0775)5  = $100, 000     (1.0775)  0.0775    = $100, 000  4.0192 1.0775 = $433, 064.19

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 95. Noel Klinger is planning to invest in an insurance company product. The product will pay $12,500 at the end of this year. Thereafter, the payments will grow annually at a 2.5 percent rate forever. Jack will be able to invest his cash flows at a rate of 5.5 percent. What is the present value of this investment cash flow stream? (Round to the nearest dollar.) A) $326,908 B) $312,766 C) $416,667 D) $446,667 Ans: C Feedback: Cash flow at t=1 = CF1 = $12,500 Annual growth rate = g = 2.5% Discount rate = i = 5.5% Present value of growing perpetuity = PVP PVA∞ = CF1 = $12,500 (i – g) (0.055 – 0.03) = $416,666.67

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 96. Bryant Investments is putting out a new product. The product will pay out $32,000 in the first year, and after that the payouts will grow by an annual rate of 2.75 percent forever. If you can invest the cash flows at 7.25 percent, how much will you be willing to pay for this perpetuity? (Round to the nearest dollar.) A) $721,111 B) $633,111 C) $531,111 D) $711,111 Ans: D Feedback: Cash flow at t = 1 = CF1 = $32,000 Annual growth rate = g = 2.75% Discount rate = i = 7.25% Present value of growing perpetuity = PVP PVA∞ = CF1 = $12,500 (i – g) (0.0725 – 0.0275) = $711,111.11

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 97. Shelton Enterprises is expecting tremendous growth from its newest boutique store. Next year the store is expected to bring in net cash flows of $675,000. The company expects its earnings to grow annually at a rate of 13 percent for the next 15 years. What is the present value of this growing annuity if the firm uses a discount rate of 18 percent on its investments? (Round to the nearest dollar.) A) $6,448,519 B) $6,750,000 C) $7,115,449 D) $5,478,320 Ans: A Feedback: Time of growth = n = 15 years Next year's expected net cash flow = CF1 = $675,000 Expected annual growth rate = g = 13% Firm's required rate of return = i = 18% Present value of growing annuity = PVAn

= $13,500,000 × 0.477668109 = $6,448,519.47

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 98. Foodelicious Corp. is evaluating whether it should take over the lease of an ethnic restaurant in Manhattan. The current owner had originally signed a 25-year lease, of which 16 years still remain. The restaurant has been growing steadily at a 7 percent growth for the last several years. Foodelicious Corp. expects the restaurant to continue to grow at the same rate for the remaining lease term. Last year, the restaurant brought in net cash flows of $310,000. If the firm evaluates similar investments at 15 percent, what is the present value of this investment? (Round to the nearest dollar.) A) $2,966,350 B) $2,838,182 C) $3,109,460 D) $2,709,124 Ans: B Feedback: Time for lease to expire = n = 16 years Last year's net cash flow = CF0 = $310,000 Expected annual growth rate = g = 7% Firm's required rate of return = i = 15% Expected cash flow next year = CF1 = $310,000(1 + g) = $310,000(1.07) = $331,700 Present value of growing annuity = PVAn n   1.07 16  CF1   1 + g   $331, 700 PVAn =  1 −   1 −   =   (i − g )   1 + i   (0.15 − 0.07)   1.15  

= $4,146, 250  0.684518 = $2, 838,181.52

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 99. Beautinator Cosmetics borrowed $152,300 from a bank for three years. If the quoted rate (APR) is 11.75 percent, and the compounding is daily, what is the effective annual rate (EAR)? (Round to one decimal place.) A) 11.7% B) 14.3% C) 12.5% D) 11.6% Ans: C Feedback: Loan amount = PV = $152,300 Interest rate on loan = i = 11.75% Frequency of compounding = m = 365 Effective annual rate = EAR m1

i    0.1175  EAR = 1 +  − 1 = 1 + 365   m  = 1.12455 − 1 = 12.46%

365

−1

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 100. Surreal Corp. has borrowed to invest in a project. The loan calls for a payment of $17,500 every month for three years. The lender quoted Surreal a rate of 8.40 percent with monthly compounding. At what rate would you discount the payments to find amount borrowed by Surreal Corp.? (Round to two decimal places.) A) 8.40% B) 8.73% C) 8.95% D) 8.44% Ans: B Feedback: Loan amount = PV Interest rate on loan = i = 8.4% Frequency of compounding = m = 12 Effective annual rate = EAR m1

i   0.084  EAR = 1 +  − 1 = 1 + −1 12   m  = 1.0873 − 1 = 8.73% To discount present or future value of cash flows, the most appropriate rate is the EAR, that is, 8.73 percent.

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 101. How is an annuity due different from the ordinary annuity? Ans: When constant cash flows are received or paid at the end of each period for a length of time, we have an ordinary annuity. If the same cash flows happen at the beginning of each period, we call it an annuity due. Cash flows received at the beginning of each period earn interest for an extra period compared to cash flows received at the end of each period for an investment of the same time frame. Thus, annuity dues have higher values than ordinary annuities.

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 102. The annual percentage rate (APR) is not the appropriate rate to perform present or future value calculations. Explain this statement. Ans: The APR is the annualized interest rate using simple interest. In other words, the APR is the simple interest charged per period multiplied by the number of periods per year. However, the APR ignores the impact of compounding on cash flows. This makes it an inappropriate discount rate for doing present and future value calculations. An appropriate rate for such calculations is the effective annual rate (EAR).

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Legal/Regulatory Perspective 103. What was the purpose behind the passage of the two consumer protection acts discussed in this chapter? Ans: In 1968, Congress passed the Truth-in-Lending Act to ensure that all borrowers receive meaningful information about the cost of credit so they can make intelligent economic decisions. The act applies to all lenders that extend credit to consumers, and it covers credit card loans, auto loans, home mortgage loans, home equity loans, home improvement loans, and some small business loans. Similar legislation, the so-called Truth-in-Savings Act, applies to consumer savings vehicles such as consumer certificates of deposits (CDs). These two pieces of legislation require by law that the APR be disclosed on all consumer loans and savings plans and that it be prominently displayed on advertising and contractual documents.

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 104. What are the three ways of interest rate quoted in the market place? Ans: The interest rates in the marketplace are quoted in three ways. 1. The quoted interest rate. This is an interest rate that has been annualized by multiplying the rate per period by the number of compounding periods. The annual percentage rate (APR) is an example. All consumer borrowing and lending rates are annualized in this manner. 2. The interest rate per period. The bank credit card rate of 1 percent per month is an example of this kind of rate. You can find the interest rate per period by dividing the quoted interest rate by the number of compounding periods. 3. The effective annual interest rate (EAR). This is the interest rate actually paid (or earned) after accounting for compounding. Sometimes it is difficult to distinguish a quoted rate from an EAR. Generally, however, an annualized consumer rate is an APR rather than an EAR.

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Chapter 07: Risk and Return Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 1. The rate of return that investors require for an investment depends on the risk associated with that investment. A) True b) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 2. The capital appreciation component of a stock's return considers the change in price of a stock divided by the initial price of the stock. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 3. If the price of an asset has not increased or decreased since the original purchase of the asset, then the total return of the asset (if no dividends were paid during the period) is equal to the capital appreciation component return. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 4. The income component of return for a common stock comes from the cash dividend a firm pays. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy 5. If the capital appreciation return from owning a stock is positive, then the total return from owning the same stock can be negative. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 6. In order to keep the total return of a stock equal to 100 percent, the income component for that stock must be zero. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 7. Robert paid $100 for a stock one year ago. The total return on the stock was 10 percent. Therefore, the stock must be selling for $110 today. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 8. Whenever the outcome of an event has a number of different possibilities that have equal probability of occurrence, then the expected value of the outcome is equal to the simple average of the individual events. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 9. You have placed a wager such that you will either receive nothing if you lose the bet or you will receive $10 if you win the bet. If the expected cash receipt is $9, then there is a 100 percent probability that you will win the wager. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 10. The expected return on the market portfolio is equal to the market risk premium. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 11. The variance of a distribution can be a negative value. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 12. The standard deviation of a distribution can be a negative value. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 13. The normal distribution is completely described by its mean and standard deviation where 50 percent of the distribution's probability is less than the mean and 50 percent greater than the mean. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 14. The variance is denominated in squared units, whereas the standard deviation is denominated in the same units as the expected value. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 15. The best measure of assessing a risk within an investment is its variance. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 16. Variance is equal to the square root of standard deviation. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 17. If you are calculating the variance and standard deviation of returns on a stock, the variance will always be larger than the standard deviation. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 18. The coefficient of variation divides the variance of the returns of an asset by the expected rate of return of that asset. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 19. The coefficient of variation is a good measure of the amount of risk that an asset will contribute to a diversified portfolio of assets. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 20. If you are building a portfolio, then you desire those assets to have a correlation coefficient of one. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 21. If the returns on two assets have a correlation coefficient of one, then there are no benefits of diversification by combining these assets in a two-asset portfolio. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 22. Utilizing the fact that values of two or more assets do not always move in the same direction at the same time in order to reduce the risk of a portfolio is called diversification. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 23. If you are trying to determine whether to purchase Security A or Security B as the only holding in your portfolio, then you can consider the coefficient of variation in order to understand the risk-return relationship of the individual securities. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: corporate Finance AICPA: Measurement 24. The coefficient of variation is useful when deciding which individual stocks to add to your diversified portfolio. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 25. If two assets with return on correlation coefficients of less than one make up a portfolio, then the portfolio does not take advantage of any diversification benefits. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 26. If the covariance between the returns on two assets is equal to zero, then the correlation coefficient must also be zero. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 27. If the distribution of returns on an asset has a variance of zero, then covariance of returns between that asset and the returns on any other asset must be equal to zero. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 28. If you were to completely diversify your portfolio by purchasing a portion of every asset in the investment universe, then the expected return of your portfolio is equal to the risk-free rate. A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 29. Complete diversification means that the portfolio is no longer subject to market risk. A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 30. Given the historical information in the chapter, the beta of a small stock should be greater than the beta of a corporate bond. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 31. The appropriate measure of risk for a diversified portfolio is beta. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 32. The market risk-premium is equal to the expected return on the market less the risk-free rate of return. A) True B) False Ans: A

Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 33. If you know the risk-free rate, the market risk-premium, and the beta of a stock, then using the Capital Asset Pricing Model (CAPM) you will be able to calculate the expected rate of return for the stock. A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Measurement

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34.

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Which of the following statements is correct? A) The greater the risk associated with an investment, the lower the return investors expect from it. B) When choosing between two investments that have the same level of risk, investors prefer the investment with the higher return. C) If two investments have the same expected return, investors prefer the riskiest alternative. D) When choosing between two investments that have the same level of risk, investors prefer the investment with the lower return. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 35. Gunther earned a 62.5 percent return on a stock that he purchased one year ago. The stock is now worth $12, and he received a dividend of $1 during the year. How much did Gunther originally pay for the stock? A) $7.00 B) $7.50 C) $8.00 D) $8.50 Ans: C Feedback:

$12 − $ X + $1 = 0.625, $ X = $8 $X

Original price of the stock = $8

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 36. Moshe purchased a stock for $30 last year. He found out today that he had a –100 percent return on his investment. Which of the following must be true? A) The stock is worth $30 today. B) The stock is worth $0 today. C) The stock paid no dividends during the year. D) Both B and C must be true. Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 37. Barbra purchased a piece of real estate last year for $85,000. The real estate is now worth $102,000. If Barbra needs to have a total return of 25 percent during the year, then what is the dollar amount of income that she needs to have to reach her objective? A) $3,750 B) $4,250 C) $4,750 D) $5,250 Ans: B Feedback:

$102, 000 − $85, 000 + $ X = 0.25, $ X = $4, 250 $85, 000

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 38. Books Brothers stock was priced at $15 per share two years ago. The stock sold for $13 last year and now it sells for $18. What was the total return for owning Books Brothers stock during the most recent year? Assume that no dividends were paid. Round your answer to the nearest percent. A) 17% B) 20% C) 23% D) 38% Ans: D Feedback:

$18 − $13 = 0.3846 $13

Total rate of return = 38.46% OR 38% (rounded).

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 39. George Wilson purchased Bright Light Industries common stock for $47.50 on January 31, 2010. The firm paid dividends of $1.10 during the last 12 months. George sold the stock today (January 30, 2011) for $54.00. What is George’s holding period return? A) 16.00% B) 14.00% C) 11.00% D) 19.00% Ans: A Feedback:

R1 =

P1 − P 0 + CF 1 $54.00 − $47.50 + $1.10 = = .1600 = 16.00% P0 $47.50

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 40. In a game of chance, the probability of winning a $50 prize is 40 percent, and the probability of winning a $100 prize is 60 percent. What is the expected value of the prize in the game? A) $50 B) $75 C) $80 D) $100 Ans: C Feedback: Expected value = $50 × (0.4) + $100 × (0.6) = $80

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 41. In a game of chance, the probability of winning a $50 is 40 percent and the probability of losing a $50 prize is 60 percent. What is the expected value of the prize in the game? A) $10 B) $0 C) $10 D) $25 Ans: A Feedback: Expected value = $50 × (0.4) – $50 × (0.6) = $10

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 42. Use the following table to calculate the expected return from an asset. Return Probability 0.1 0.25 0.2 0.5 0.25 0.25 A) 15.00% B) 17.50% C) 18.75% D) 20.00% Ans: C Feedback: Expected return from an assets = (0.1) × (0.25) + (0.2) × (0.5) + (0.25) × (0.25) = 0.1875 = 18.75%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 43. Use the following table to calculate the expected return from an asset. Return Probability 0.05 0.1 0.1 0.15 0.15 0.5 0.25 0.25 A) 12.50% B) 13.75% C) 15.75% D) 16.75% Ans: C Feedback: Expected return from an asset = (0.05) × (0.1) + (0.1) × (0.15) + (0.15) × (0.5) + (0.25) × (0.25) = 0.1575 = 15.75%

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 44. The expected return for Stock Z is 30 percent. If we know the following information about Stock Z, then what return will it produce in the Lukewarm state of the world? Return Probability Poor 0.2 0.25 Lukewarm ? 0.5 Dynamite 0.4 0.25 A) 20% B) 30% C) 40% D) It is impossible to determine. Ans: B Feedback: Expected return from stock Z in Lukewarm state of the world = (0.2) × (0.25) + (X) × (0.5) + (0.4) × (0.25) = 0.3 , X = 0.3

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 45. The expected return for Stock V is 24.5 percent. If we know the following information about Stock Z, then what is the probability of the Dynamite state of the world occurring? Return Probability Poor 0.15 0.2 Lukewarm 0.28 0.7 Dynamite 0.19 ? A) 5% B) 10% C) 15% D) 20% Ans: B Feedback: Probability of the Dynamite state of the world occurring = 0.2 + 0.7 + X = 1.0 ===> X = 0.1 or 10%

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 46. Ahmet purchased a stock for $45 one year ago. The stock is now worth $65. During the year, the stock paid a dividend of $2.50. What is the total return to Ahmet from owning the stock? A) 5% B) 44% C) 35% D) 50% Ans: D Feedback:

$65 − $45 + $2.50 = 0.5 = 50% $45

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 47. Julio purchased a stock one year ago for $27. The stock is now worth $32, and the total return to Julio for owning the stock was 37 percent. What is the dollar amount of dividends that he received for owning the stock during the year? Round your final answer to nearest whole dollar. A) $4 B) $5 C) $6 D) $7 Ans: B Feedback:

$32 − $27 + $ X = 0.37, $ X = $5 $27

Dividend paid = $5

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 48. Francis purchased a stock one year ago for $20, and it is now worth $24. The stock paid a dividend of $3 during the year. What was the stock's rate of return from capital appreciation during the year? A) 17% B) 20% C) 29% D) 35% Ans: B Feedback:

$24 − $20 = 0.20 $20

Capital appreciation percentage = 20 %

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 49. Gwen purchased a stock one year ago for $25, and it is now worth $31. The stock paid a dividend of $1.50 during the year. What was the stock's rate of return from dividend income during the year? A) 6% B) 15% C) 24% D) 26% Ans: A Feedback:

$1.50 = .06 $25 Stock’s rate of return = 6 %

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 50. Genaro needs to capture a return of 40 percent for his one-year investment in a property. He believes that he can sell the property at the end of the year for $150,000 and that the property will provide him with rental income of $25,000. What is the maximum amount that Genaro should be willing to pay for the property? A) $112,500 B) $125,000 C) $137,500 D) $150,000 Ans: B Feedback:

$150, 000 − $ X + $25, 000 = 0.4, $ X = $125, 000 $X

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 51. Serox stock was selling for $20 two years ago. The stock sold for $25 one year ago, and it is currently selling for $28. Serox pays a $1.10 dividend per year. What was the rate of return for owning Serox in the most recent year? (Round to the nearest percent.) A) 12% B) 16% C) 32% D) 40% Ans: B Feedback:

$28 − $25 + $1.1 = 0.164 $25

Total rate of return = 16% (Rounded off)

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 52. Security Analysts that have evaluated Concordia Corporation, have determined that there is a 15% chance that the firm will generate earnings per share of $2.40; a 60% probability that the firm will generate earnings per share of $3.10; and a 25% probability that the firm will generate earnings per share of $3.80. What are the expected earnings per share for Concordia Corporation? (Round off to the nearest $0.01) A) $3.10 B) $3.17 C) $2.75 D) $2.91 Ans: B Feedback: Probability Projected Expected EPS EPS 15.00% 60.00% 25.00% 100.00%

$ 2.40 3.10 3.80

$ 0.36 1.86 0.95 $ 3.17

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 53. Niles is making an investment with an expected return of 12 percent. If the standard deviation of the return is 4.5 percent, and if Niles is investing $100,000, then what dollar amount is Niles 90 percent sure that he will have at the end of the year? (Do not round intermediate computations). A) $100,000.00 B) $104,597.50 C) $116,500.00 D) $119,402.50 Ans: B Feedback: { 1 + [0.12 – 1.645 (0.045)]} × $100,000 = $104,597.50 Number of standard deviations from mean for 90% observations is 1.645

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 54. Given the historical information in the chapter, which of the following investment classes had the greatest average return? A) Intermediate-Term Government Bonds B) Long-Term Government Bonds C) Large U.S. Stocks D) Small U.S. Stocks Ans: D

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 55. Given the historical information in the chapter, which of the following investment classes had the greatest variability in returns? A) Intermediate-Term Government Bonds B) Long-Term Government Bonds C) Large U.S. Stocks D) Small U.S. Stocks Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 56. The expected return for an asset is 18.75 percent. If the return distribution for the asset is described as in the following table, what is the variance for the asset's returns? Round intermediate computations and final answer to 6 decimal places. Return Probability 0.10 0.25 0.20 0.50 0.25 0.25 A) 0.002969 B) 0.000613 C) 0.015195 D) 0.054486 Ans: A Feedback: (0.25) × (0.1 – 0.1875)2 + (0.5) × (0.2– 0.1875) 2 + (0.25) × (0.25 – 0.1875) 2 = 0.002969

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 57. The expected return for the asset shown in the following table is 18.75 percent. If the return distribution for the asset is described as below, what is the standard deviation for the asset's returns? Round intermediate computations and final answer to 6 decimal places. Return Probability 0.10 0.25 0.20 0.50 0.25 0.25 A) 0.002969 B) 0.000613 C) 0.015195 D) 0.054486 Ans: D Feedback: Standard Deviation = { (0.25) × (0.10 – 0.1875)2 + (0.5) × (0.2 – 0.1875) 2 + (0.25) × (0.25 – 0.1875) 2 }1/2 = 0.054486

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 58. You have observed that the average size of a particular goldfish is 1.5 inches long. The standard deviation of the size of the goldfish is 0.25 inches. What is the size of a goldfish such that 90 percent of the goldfish are smaller from such size? Assume a normal distribution for the size of goldfish. Round your final answer to two decimal places. A) 1.01 inches B) 1.09 inches C) 1.91 inches D) 1.99 inches Ans: C Feedback: 1.5 + 1.645 × (0.25) = 1.91 inches Number of standard deviations from mean for 90% observations is 1.645

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 59. You know that the average college student eats 0.75 pounds of food at lunch. If the standard deviation is 0.2 pounds of food, then what is the total amount of food that a cafeteria should have on hand to be 90 percent confident that it will not run out of food when feeding 50 college students? A) 17.90 pounds B) 21.05 pounds C) 53.95 pounds D) 57.10 pounds Ans: C Feedback: 50 students × {0.75 pounds per student + 1.645 × (0.2 pounds per student)} = 53.95 pounds of food required. Number of standard deviations from mean for 90% observations is 1.645

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 60. If a random variable follows a normal distribution, what is the probability that the random variable is larger than 1.96 standard deviations larger than the mean? A) 1.25% B) 2.50% C) 3.75% D) 5.00% Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 61. If a random variable follows a normal distribution, what is the probability that the random variable is larger than 1.96 standard deviations below the mean? A) 95.00% B) 96.25% C) 97.50% D) 98.75% Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 62. Tommie has made an investment that will generate returns that are subject to the state of the economy during the year. Use the following information to calculate the standard deviation of the return distribution for Tommie's investment. Do not round intermediate computations. Round your final answer to four decimal places. State Return Probability Weak 0.13 0.30 OK 0.20 0.40 Great 0.25 0.30 A) 0.0453 B) 0.0467 C) 0.0481 D) 0.0495 Ans: B Feedback: E(R) = (0.30 × 0.13) + (0.40 × 0.20) + (0.30 × 0.25) = 0.194 Var (R) = 0.30 × (0.13 – 0.194)2 + 0.4 × (0.20 – 0.194)2 + 0.30 × (0.25 – 0.194)2 = 0.002184 Std (R) = √(0.002184)= 0.0467 (rounded)

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 63. Elrond has made an investment that will generate returns that are subject to the state of the economy. Use the following information to calculate the variance of the return distribution for Elrond's investment. Do not round intermediate computations. Round your final answer to four decimal places. State Return Probability Weak 0.10 0.8 OK 0.17 0.1 Great 0.28 0.1 A) 0.0536 B) 0.0543 C) 0.0550 D) 0.0031 Ans: D Feedback: E(R) = (0.8 × 0.10) + (0.1 × 0.17) + (0.1 × 0.28) = 0.125 Var(R) = 0.8 × (0.10 – 0.125)2 + 0.1 × (0.17 – 0.125)2 + 0.1 × (0.28 – 0.125)2 = 0.0031 (rounded)

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 64. Stock A has exhibited a standard deviation in stock returns of 0.5, whereas Stock B has exhibited a standard deviation of 0.6. The correlation coefficient between the stock returns is 0.5. What is the variance of a portfolio composed of 70 percent Stock A and 30 percent Stock B? A) 0.1549 B) 0.2179 C) 0.4668 D) 0.5500 Ans: B Feedback:

Var ( port ) = x12 12 + x22 22 + 2 x1 x21 2 12 = (0.7)2 (0.5) 2 + (0.3) 2 (0.6) 2 + 2(0.7)(0.3)(0.5)(0.6)(0.5) = 0.2179

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 65. Aquaman Stock has exhibited a standard deviation in stock returns of 0.7, whereas Green Lantern Stock has exhibited a standard deviation of 0.8. The correlation coefficient between the stock returns is 0.1. What is the standard deviation of a portfolio composed of 70 percent Aquaman and 30 percent Green Lantern? Round the answer to five decimal points. A) 0.32122 B) 0.54562 C) 0.56676 D) 0.75000 Ans: C Feedback:

Var ( port ) = x12 12 + x22 22 + 2 x1 x21 2 12 = (0.7) 2 (0.7) 2 + (0.3) 2 (0.8) 2 + 2(0.7)(0.3)(0.7)(0.8)(0.1) = 0.32122 Std ( port ) = Sqrt (Var ( port )) = Sqrt (0.32122) = 0.566763

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: IMA: Quantitative Methods AICPA: Measurement 66. View Point Industries has forecast a rate of return of 20.00% if the economy booms (25.00% probability); a rate of return of 15.00% if the economy is in a growth phase (45.00% probability); a rate of return of 2.50% if the economy is in decline (20.00% probability); and a rate of return of –15.00% if the economy is in a depression (10.00% probability). What is View Point’s standard deviation of returns? Do not round intermediate computations. Round your final answer to two decimal points. A) 17.31% B) 9.25% C) 15.00% D) 10.29% Ans: D Feedback: State of the Rate of Probability Expected Deviation Squared Economy return return deviation Probability × (Expected return Rate of return)^2

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Fundamentals of Corporate Finance 3e

Boom Growth Decline Depression

0.2 0.15 0.025 −0.15

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0.25 0.45 0.2 0.1

0.05 0.0675 0.005 −0.015 0.1075

0.15 0.02250 0.0825 0.00681 0.02 0.00040 −0.135 0.01823 Mean Variance Std Devn Total variance = 1.059% Standard deviation = √(1.059) = 10.29%

0.00563 0.00306 0.00008 0.00182 0.0105903 10.29%

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 67. Braniff Ground Services stock has an expected return of 9 percent and a variance of 0.25 percent. What is the coefficient of variation for Braniff? Round your final answer to four decimal places. A) 0.0278 B) 0.5556 C) 1.8001 D) 36.0002 Ans: B Feedback: σ √(0.0025) Coefficient of Variation = = = 0.5556 (rounded) E(R) 0.09

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: IMA: Quantitative Methods AICPA: Measurement 68. Sayers purchased a stock with a coefficient of variation equal to 0.125. The expected return on the stock is 20 percent. What is the variance of the stock? A) 0.000625 B) 0.025000 C) 0.625000 D) 0.790500 Ans: A Feedback:

Coefficient

Variation =

 E ( R)

1 2 2

( ) = 0.125,  = 0.000625 2

0.20

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 69. You have invested 40 percent of your portfolio in an investment with an expected return of 12 percent and 60 percent of your portfolio in an investment with an expected return of 20 percent. What is the expected return of your portfolio? A) 15.2% B) 16.0% C) 16.8% D) 17.6% Ans: C Feedback: E(R) = 0.4 × 0.12 + 0.60 × 0.20 = 0.168 = 16.8%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 70. You have invested 20 percent of your portfolio in Homer, Inc., 40 percent in Marge Co., and 20 percent in Bart Resources. What is the expected return of your portfolio if Homer, Marge, and Bart have expected returns of 2 percent, 18 percent, and 3 percent, respectively? A) 7.7% B) 8.2% C) 8.7% D) 9.2% Ans: B Feedback: E(R) = (0.2 × 0.02) + (0.4 × 0.18) + (0.2 × 0.03) = 0.082 = 8.2%

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 71. You invested $3,000 in a portfolio with an expected return of 10 percent and $2,000 in a portfolio with an expected return of 16 percent. What is the expected return of the combined portfolio? A) 6.2% B) 12.4% C) 13.0% D) 13.6% Ans: B Feedback:

3, 000 2, 000 (0.1) + (0.16) = 0.124 5, 000 5, 000 = 12.4%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 72. Given the returns for two stocks with the following information, calculate the covariance of the returns for the two stocks. Assume the expected return is 10.8 percent for Stock 1 and 9.7 percent for Stock 2. Prob Stock 1 Stock 2 0.4 0.09 0.11 0.5 0.11 0.08 0.1 0.17 0.13 A) 0.000094 B) 0.000516 C) 0.000321 D) 0.717507 Ans: A Feedback: Cov(R1,R2) = 0.4 × (0.09 − 0.108) × (0.11− 0.097) + 0.5 × (0.11− 0.108) × (0.08 − 0.097) + 0.1 × (0.17 − 0.108) × (0.13 − 0.097) = 0.000094

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 73. Given the returns for two stocks with the following information, calculate the correlation coefficient of the returns for the two stocks. Assume the expected return for Stock 1 is 10.8 percent and 9.7 percent for Stock 2. Do not round intermediate computations. Prob Stock 1 Stock 2 0.4 0.09 0.11 0.5 0.11 0.08 0.1 0.17 0.13 A) 0.230967 B) –0.00002548 C) 0.00032100 D) 0.17671455 Ans: A Feedback: From the solution to Problem 72, we find that the covariance between the stocks is 0.000094. We must now solve for the standard deviation of the returns of each individual stock.

 12 = 0.4(0.09 − 0.108) 2 + 0.5(0.11 − 0.108) 2 + 0.1(0.17 − 0.108)2 = 0.000516,  1 = 0.02271563 𝜎12 = (0.5(0.11 − 0.144)2 + 0.3(0.17 − 0.1444)2 + 0.2(0.19 − 0.144)2 = 0.001204 𝜎1 = 0.03469870

𝜌𝑅1,2 =

0.000094 = 0.230967 (0.02271563)(0.01791647)

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 74. Given the returns for two stocks with the following information, calculate the covariance of the returns for the two stocks. Assume the expected return is 14.4 percent for Stock 1 and 15.9 percent for Stock 2. Round your final answer to five decimal places. Prob Stock 1 Stock 2 0.5 0.11 0.18 0.3 0.17 0.15 0.2 0.19 0.12 A) 0.00120 B) 0.00054 C) −0.00079 D) –0.33720 Ans: C Feedback: Cov(R1,R2) = 0.5 × (0.11 – 0.144) × (0.18 – 0.159) + 0.3 × (0.17 – 0.144) × (0.15 – 0.159) + 0.2 × (0.19 – 0.144) × (0.12 – 0.159) = −0.00079

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 75. Given the returns for two stocks with the following information, calculate the correlation coefficient of the returns for the two stocks. Assume the expected return is 14.4 percent for Stock 1 and 15.9 percent for Stock 2. Do not round intermediate computations. Prob Stock 1 Stock 2 0.5 0.3 0.2

0.11 0.17 0.19

0.18 0.15 0.12

A) 0.00120 B) 0.00054 C) –0.00271 D) -0.97169 Ans: D Feedback: Cov(R1,R2) = 0.5 × (0.11 – 0.144) × (0.18 – 0.159) + 0.3 × (0.17 – 0.144) × (0.15 – 0.159) + 0.2 × (0.19 – 0.144) × (0.12 – 0.159) = −0.00079 𝜎12 = 0.5(0.11 − 0.144)2 + 0.3(0.17 − 0.144)2 + 0.2(0.10 − 0.1444)2 = 0.001204 𝜎1 = 0.03469870

 22 = 0.5(0.18 − 0.159) 2 + 0.3(0.15 − 0.159) 2 + 0.2(0.12 − 0.159) 2 = 0.000549,  2 = 0.02343075 𝜌𝑅1,2 =

−0.00079 = −0.9716899 (0.03469870)(0.02343075)

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 76. The covariance of the returns between Stock A and Stock B is 0.0087. The standard deviation of Stock A is 0.26, and the standard deviation of Stock B is 0.37. What is the correlation coefficient between the returns of the two stocks? A) 0.090437 B) 0.096200 C) 0.90437 D) 0.96200 Ans: A Feedback:

=

Cov( R1 , R2 )

 1 2

0.0087 = 0.090437 (0.26)(0.37)

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 77. The covariance of the returns between Wildcat Stock and Sun Devil Stock is 0.09875. The variance of Wildcat is 0.2116, and the variance of Sun Devil is 0.1369. What is the correlation coefficient between the returns of the two stocks? A) 0.170200 B) 0.293347 C) 0.340823 D) 0.580199 Ans: D Feedback: 𝐶𝑜𝑣(𝑅1, 𝑅2) 0.09875 𝜌= = = 0.580199 𝜎1𝜎2 √(0.2116 × 0.1369)

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 78. Horse Stock returns have exhibited a standard deviation of 0.57, whereas Mod T Stock returns have a standard deviation of 0.63. The correlation coefficient between the returns is 0.078042. What is the covariance of the returns? Round your answer to six decimal places. A) 0.028025 B) 0.217327 C) 0.359100 D) 0.993094 Ans: A Feedback: 𝐶𝑜𝑣 (𝑅1 𝑅2 ) = 𝜌12 𝜎1 𝜎2 = (0.078042) × (0.57) × (0.63) = 0.028025 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 79. Most of the risk-reduction benefits from diversification can be achieved in a portfolio consisting of A) 5 to 10 assets. B) 10 to 15 assets. C) 15 to 20 assets. D) 20 to 25 assets. Ans C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 80. Which of the following investors should be willing to pay the highest price for an asset? A) An investor with a single-asset portfolio. B) An investor with a diversified portfolio. C) An investor who is not completely diversified. D) An investor who is so risk-averse that he does not recognize the benefits of diversification. Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 81. Which of the following is the best measure of the systematic risk in a portfolio? A) Variance B) Standard deviation C) Covariance D) Beta Ans: D

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 82. A portfolio with a level of systematic risk is the same as that of the market has a beta that is A) equal to zero. B) equal to one. C) less than the beta of the risk-free asset. D) less than zero. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 83. The beta of Elsenore, Inc., stock is 1.6, whereas the risk-free rate of return is 8 percent. If the expected return on the market is 15 percent, then what is the expected return on Elsenore? A) 11.20% B) 19.20% C) 24.00% D) 32.00% Ans: B Feedback:

E ( REls ) = Rrf +  Els ( E ( RM ) − Rrf ) = 0.08 + 1.6(0.15 − 0.08) = 0.1920

= 19.20%

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Fiancne AICPA: Measurement 84. The beta of Ricci Co.'s stock is 3.2, whereas the risk-free rate of return is 9 percent. If the expected return on the market is 18 percent, then what is the expected return on Ricci Co.? A) 28.80% B) 37.80% C) 48.60% D) 57.60% Ans: B Feedback:

E ( RRicci ) = Rrf +  Ricci ( E ( RM ) − Rrf ) = 0.09 + 3.2(0.18 − 0.09) = 0.378

= 37.8%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 85. The risk-free rate of return is currently 3 percent, whereas the market risk premium is 6 percent. If the beta of Lenz, Inc., stock is 1.8, then what is the expected return on Lenz? A) 8.40% B) 10.80% C) 13.80% D) 19.20% Ans: C Feedback: E(RLenz) = Rrf + βLenz (E(RM) – Rrf) = 0.03 + (1.8 × 0.06) = 0.138 = 13.8 %

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 86. The expected return on Kiwi Computers stock is 16.6 percent. If the risk-free rate is 4 percent and the expected return on the market is 10 percent, then what is Kiwi's beta? A) 1.26 B) 2.10 C) 2.80 D) 3.15 Ans: B Feedback:

E ( RKiwi ) = 0.166 = Rrf +  Kiwi ( E ( RM ) − Rrf ) = 0.04 +  Kiwi (0.10 − 0.04)   Kiwi = 2.1

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 87. The expected return on Mike's Seafood stock is 17.9 percent. If the expected return on the market is 13 percent and the beta for Kiwi is 1.7, then what is the risk-free rate? A) 4.5% B) 5.0% C) 5.5% D) 6.0% Ans: D Feedback:

E ( RMike ) = 0.179 = Rrf +  Mike ( E ( RM ) − Rrf ) = Rrf + 1.7(0.13 − Rrf )  Rrf = 0.06

= 6%

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 88. The expected return on Karol Co. stock is 16.5 percent. If the risk-free rate is 5 percent and the beta of Karol Co is 2.3, then what is the risk premium on the market? A) 2.5% B) 5.0% C) 7.5% D) 10.0% Ans: B Feedback:

E ( RKarole ) = 0.165 = Rrf +  Karol ( E ( RM ) − Rrf ) = 0.05 + 2.3( Risk Pr emium)  Risk Pr emium = 0.05

0.05 + 2.3 (Risk premium) = 0.165. Therefore Risk premium = 0.05 = 5%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 89. Which of the following represents a plot of the relation between expected return and systemic risk? A) The beta coefficient B) The covariance of returns line C) The security market line D) The variance Ans: C

Format: Essay Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Measurement 90. Explain the difference between systematic risk and unsystematic risk. Ans: Systematic risk is the risk that cannot be diversified away and describes the risk that is inherent in the general economic world of investing. Systematic risk cannot be eliminated through diversification. Unsystematic risk is risk that can be diversified away and describes a risk that is unique to a particular investment.

Format: Essay Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Quantitative Methods AICPA: Measurement 91. While performing the regression analysis of historical returns of a stock with a historical return of a general market index, you would plot the line of best fit through those data points. The slope of that line represents the beta of the stock in question. However, in most instances the data points do not lie exactly on that line. Explain the reason. Ans: The slope of the line of best fit describes the beta of the stock in question that is capturing the systematic risk inherent in investing in that stock. The vertical distance between each point and the line represents the unsystematic, or diversifiable risk in investing in the stock.

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Fundamentals of Corporate Finance 3e

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Chapter 8: Bond Valuation and the Structure of Interest Rates Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. The largest investors in corporate bonds are state government agencies. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2. The largest investors in corporate bonds are big institutional investors such as life insurance companies and pension funds. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. Most secondary market transactions for corporate bonds take place on the New York Stock Exchange. A) True B) False Ans: B

8-1

Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. Most secondary market transactions for corporate bonds take place through dealers in the overthe-counter (OTC) market. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. A thin market for a security implies a high frequency of trades for that type of security in the markets. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. Corporate bonds have a thin market relative to market for corporate stocks. A) True B) False Ans: A

8-2

Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. Prices in the corporate bond market tend to be more volatile than securities sold in markets with greater trading volumes. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8. Vanilla bonds have coupon payments that are fixed for the life of the bond, with the principal being repaid at maturity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 9. The face or par value for most corporate bonds is equal to $1,000, and it is the principal amount owed to bondholders at maturity. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 10. Zero coupon bonds sell well above their par value because they offer no coupons. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 11. Convertible bonds can be converted into shares of common stock at some predetermined ratio at the discretion of the bondholder. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 12. The value, or price, of any asset is the present value of its future cash flows. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 13. The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Risk Analysis 14. Interest rate risk is the risk that bond prices will fluctuate as interest rate changes. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 15. As interest rates fall, the prices of bonds decline. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Risk Analysis 16. Higher coupon bonds have greater interest rate risk. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 17. All other things being equal, a given change in the interest rates will have a greater impact on the price of a low-coupon bond than a higher-coupon bond with the same maturity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 18. Bonds with a call provision pay lower yields than comparable noncallable bonds. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 19. The risk that the lender may not receive payments as promised is called default risk. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 20. U.S. Treasury securities are the best proxy measure for the risk-free rate. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 21. Upward-sloping yield curves often occur before the beginning of recession. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 22. If investors believe inflation will be increasing in the future, the prevailing yield will be downward sloping. A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 23. The real rate of interest varies with the business cycle, with the highest rates seen at the end of a period of business expansion and the lowest at the bottom of a recession. A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 24. Which of the following statements is true? A) The largest investors in corporate bonds are institutional investors such as life insurance companies and pension funds. B) The market for corporate bonds is thin compared to the market for corporate stocks. C) Prices in the corporate bond market tend to be more volatile than prices of securities sold in markets with greater trading volumes. D) All of the above are true. Ans: D

8-8

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 25. Which one of the following statements is NOT true? A) Prices in the corporate bond market tend to be more volatile than the markets for stocks or money market securities. B) Corporate bonds are more marketable than the securities that have higher daily trading volumes. C) The market for corporate bonds is thin compared to the market for corporate stocks. D) The largest investors in corporate bonds are life insurance companies and pension funds. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 26. It is easy for individuals to trade in the corporate bond market because: A) the corporate bond market is considered to be very transparent. B) prices in the corporate bond market tend to be more stable. C) centralized reporting of deals between buyers and sellers take place. D) None of the above statements is true. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 27. Which one of the following statements about vanilla bonds is NOT true? A) They have fixed coupon payments. B) The face value, or par value, for most corporate bonds is $1,000. C) Coupon payments are usually made quarterly. D) The bond's coupon rate is calculated as the annual coupon payment divided by the bond's face value. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 28. Which of the following statements is true of zero coupon bonds? A) Zero coupon bonds have no coupon payments over its life and only offer a single payment at maturity. B) Zero coupon bonds sell well below their face value (at a deep discount) because they offer no coupons. C) The most frequent and regular issuer of zero coupon securities is the U.S. Treasury Department. D) All of the above are true. Ans: D

29.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement Which of the following statements is true? A) To secure the conversion option on a bond, bondholders would be willing to pay a premium. B) Typically, the conversion ratio is set so that the firm's stock price must appreciate at least 15 to 20 percent before it is profitable to convert bonds into stock. C) Convertible bonds can be converted into shares of common stock at some predetermined ratio at the discretion of the bondholder. D) All of the above are true. Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 30. Which of the following statements is true of convertible bonds? A) The most significant disadvantage to a corporation of issuing convertible bonds is that they increase the cash that the firm must use to make interest payments. B) The typical conversion ratio is set so that the firm’s stock price must appreciate 5% or less before it is profitable for the holder to convert the bond to stock. C) Firms that issue convertible bonds can do so at a lower interest rate. D) The typical issue of convertible bonds allows the holder of the bond to convert it to preferred stock. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 31. Which of the following statements is most true about zero coupon bonds? A) They typically sell at a premium over par when they are first issued. B) They typically sell for a higher price than similar coupon bonds. C) They are always convertible to common stock. D) They typically sell at a deep discount below par when they are first issued. Ans: D

8-11

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 32. Which one of the following statements about bonds is NOT true? A) To compute a bond's price, one needs to calculate the present value of the bond's expected cash flows. B) The value, or price, of any asset is the future value of its cash flows. C) The required rate of return, or discount rate, for a bond is the market interest rate called the bond's yield to maturity D) The expected future cash flows are estimated using the coupons that the bond will pay and the maturity value to be received. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 33. If a bond's coupon rate is equal to the market rate of interest, then the bond will sell: A) at a price equal to its face value. B) at a price greater than its face value. C) at a price less than its face value. D) None of the above is true. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 34. Bonds sell at a discount when the market rate of interest is: A) less than the bond's coupon rate. B) greater than the bond's coupon rate. C) equal to the bond's coupon rate. D) None of the above is true. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 35. Bonds sell at a premium when the market rate of interest is: A) less than the bond's coupon rate. B) greater than the bond's coupon rate. C) equal to the bond's coupon rate. D) None of the above is true. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 36. In calculating the current price of a bond paying semiannual coupons, one needs to A) use double the number of years for the number of payments made. B) use the semiannual coupon. C) use the semiannual rate as the discount rate. D) All of the above need to be done. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 37. Which one of the following statements about zero coupon bonds is NOT true? A) Zero coupon bonds have no coupon payments but promise a single payment at maturity. B) Zero coupon bonds must sell for less than similar bonds that make periodic coupon payments. C) Zero coupon bonds make coupon payments but no principal payment at maturity. D) All of the above statements are true. Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 38. Briar Corp is issuing a 10-year bond with a coupon rate of 7 percent. The interest rate for similar bonds is currently 9 percent. Assuming annual payments, what is the present value of the bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $872 B) $1,066 C) $990 D) $945 Ans: A Feedback: Years to maturity = n = 10 Coupon rate = C = 7% Annual coupon = $1,000 × 0.07 = $70 Current market rate = i = 9% Present value of bond = PB

0 1 2 3 4 5 6 10 |______|_______|______|______|______|_______|_____...................._____| $70 $70 $70 $70 $70 $70 $70 $1,000 n = 10; 𝐶

C = 7%; 𝐶

𝐶

i = YTM = 9%

𝐶 +𝐹

1 2 3 𝑛 𝑛 PB = (1+𝑖) 1 + (1+𝑖)2 (1+𝑖)3 + …… (1+𝑖)𝑛 1

=C × [

1− (1+𝑖)𝑛 𝑖

1− (1.09)10 F $1,000 ] + (1+𝑖)𝑛 = $70 × [ ]+ 0.09 1.0910

= $449.24 + $422.41 = $871.65

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 39. Regatta, Inc., has six-year bonds outstanding that pay a 8.25 percent coupon rate. Investors buying the bond today can expect to earn a yield to maturity of 6.875 percent. What should the company's bonds be priced at today? Assume annual coupon payments. (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $972 B) $1,066 C) $1,014 D) $923 Ans: B Feedback: Years to maturity = n = 6 Coupon rate = C = 8.25% Annual coupon = $1,000 × 0.0825 = $82.50 Current market rate = i = 6.875% 0 1 2 3 4 |______|_________|________|________|______|...................._____| $82.50 $82.50 $82.50 $82.50 $82.50 n = 6; 𝐶

C = 8.25%; 𝐶

𝐶

i = YTM = 6.875%

𝐶 +𝐹

1 2 3 𝑛 𝑛 PB = (1+𝑖) 1 + (1+𝑖)2 (1+𝑖)3 + …… (1+𝑖)𝑛 1

=C × [

1− (1+𝑖)𝑛 𝑖

1− (1.06875)6

] + (1+𝑖)𝑛 = $82.50 × [

0.06875

$1,000

] + (1.06875)6

PV of bond = $1065.79 = $1066 (rounded)

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 40. Triumph Corp. issued five-year bonds that pay a coupon of 6.375 percent annually. The current market rate for similar bonds is 8.5 percent. How much will you be willing to pay for Triumph's bond today? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,023 B) $1,137 C) $916 D) $897 Ans: C Feedback: Years to maturity = n = 5 Coupon rate = C = 6.375% Annual coupon = $1,000 × 0.06375 = $63.75 Current market rate = i = 8.5% 𝐶

𝐶

𝐶 +𝐹

1 2 𝑛 𝑛 𝑃𝐵 = (1+𝑖) + (1+𝑖) … … … + (1+𝑖) 2 𝑛 1

=C × [

1− (1+𝑖)𝑛 𝑖

] + (1+𝑖)𝑛 = $63.75 × [

1−

1 (1.085)5

0.085

$1,000

] + (1.085)5

= $251.22 + $665.05 = $916 (rounded)

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 41. Your friend recommends that you invest in a three-year bond issued by Trimer, Inc., that will pay annual coupons of 10 percent. Similar investments today will yield 6 percent. How much should you pay for the bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,024 B) $979 C) $886 D) $1,107 Ans: D Feedback: Years to maturity = n = 3 Coupon rate = C = 10% Annual coupon = $1,000 × 0.10 = $100 Current market rate = i = 6% 𝐶

𝐶

𝐶 +𝐹

1 2 3 3 𝑃𝐵 = (1+𝑖) + (1+𝑖) … … … (1+𝑖) 2 3

𝑃𝐵 = C × [

1− (1+𝑖)𝑛 𝑖

1− (1+0.06)3

] + (1+𝑖)𝑛 = $100 × [

0.06

$1,000

] + (1+0.06)3

8-17

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 42. Kevin Rogers is interested in buying a five-year bond that pays a coupon of 10 percent on a semiannual basis. The current market rate for similar bonds is 8.8 percent. What should be the current price of this bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,048 B) $965 C) $1,099 D) $982 Ans: A Feedback: Years to maturity = n = 5 Coupon rate = C = 10% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.10/2) = $50.00 Current market rate = i = 8.8% Present value of bond = PB

8-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 43. Giant Electronics is issuing 20-year bonds that will pay coupons semiannually. The coupon rate on this bond is 7.8 percent. If the market rate for such bonds is 7 percent, what will the bonds sell for today? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,037 B) $1,085 C) $861 D) $923 Ans: B Feedback: Years to maturity = n = 20 Coupon rate = C = 7.8% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.078/2) = $39.00 Current market rate = i = 7% Present value of bond = PB

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 44. Jane Thorpe has been offered a seven-year bond issued by Barone, Inc., at a price of $943.22. The bond has a coupon rate of 9 percent and pays the coupon semiannually. Similar bonds in the market will yield 10 percent today. Should she buy the bonds at the offered price? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) Yes, the bond is worth more at $1,015. B) No, the bond is only worth $921. C) Yes, the bond is worth more at $951. D) No, the bond is only worth $912. Ans: C Feedback: Years to maturity = n = 7 Coupon rate = C = 9% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.09/2) = $45.00 Current market rate = i = 10% Present value of bond = PB

8-20

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 45. Kevin Oh is planning to sell a bond that he owns. This bond has four years to maturity and pays a coupon of 10 percent on a semiannual basis. Similar bonds in the current market will yield 12 percent. What will be the price that he will get for his bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $1,044 B) $938 C) $970 D) $1,102 Ans: B Feedback: Years to maturity = n = 4 Coupon rate = C = 10% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.10/2) = $50.00 Current market rate = i = 12% Present value of bond = PB

8-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 46. Jeremy Kohn is planning to invest in a 10-year bond that pays a 12 percent coupon. The current market rate for similar bonds is 9 percent. Assume semiannual coupon payments. What is the maximum price that should be paid for this bond? (Do not round intermediate computations. Round your final answer to the nearest dollar.) A) $951 B) $882 C) $1,033 D) $1,195 Ans: D Feedback: Years to maturity = n = 10 Coupon rate = C = 12% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.12/2) = $60.00 Current market rate = i = 9% Present value of bond = PB

8-22

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 47. Shana Norris wants to buy five-year zero coupon bonds with a face value of $1,000. Her opportunity cost is 8.5 percent. Assuming annual compounding, what would be the current market price of these bonds? (Round your answer to the nearest dollar.) A) $1,023 B) $665 C) $890 D) $1,113 Ans: B Feedback: Years to maturity = n = 5 Coupon rate = C = 0% Current market rate = i = 8.5%

8-23

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 48. The U.S. Treasury has issued 10-year zero coupon bonds with a face value of $1,000. Assume that the bond compounds interest semiannually. What will be the current market price of these bonds if the opportunity cost for similar investments in the market is 6.75 percent? (Round your answer to the nearest dollar.) A) $684 B) $860 C) $515 D) $604 Ans: C Feedback: Frequency of payment = m = 2 Years to maturity = n = 10 Coupon rate = C = 0% Current market rate = i = 6.75%

8-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 49. Robertsons, Inc., is planning to expand its specialty stores into five other states and finance the expansion by issuing 15-year zero coupon bonds with a face value of $1,000. If your opportunity cost is 8 percent and similar coupon-bearing bonds will pay semiannually, what will be the price at which you will be willing to purchase these bonds? (Round your answer to the nearest dollar.) A) $308 B) $383 C) $803 D) $866 Ans: A Feedback: Frequency of payment = m = 2

8-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 50. Jarmine Corp., is planning to fund a project by issuing 10-year zero coupon bonds with a face value of $1,000. Assuming semiannual compounding of interest, what will be the price of these bonds if the appropriate discount rate is 14 percent? (Round your answer to the nearest dollar.) A) $852 B) $258 C) $419 D) $841 Ans: B Feedback: Frequency of payment = m = 2 Years to maturity = n = 10 Coupon rate = C = 0% Current market rate = i = 14%

8-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 51. Which one of the following statements is true of a bond’s yield to maturity? A) The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. B) It is the annual yield that the investor earns if the bond is held to maturity, and all the coupon and principal payments are made as promised. C) A bond's yield to maturity changes daily as interest rates increase or decrease. D) All of the above are true. Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 52. The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments: A) exceed the price of the bond. B) equal to zero. C) equal to the price of the bond. D) less than the price of the bond. Ans: C

8-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 53. Which one of the following statements is NOT true of realized yield? A) The realized yield is the return earned on a bond given the cash flows actually received by the investor. B) The realized yield is equal to the yield to maturity even if the bond is sold prior to maturity. C) It is the interest rate at which the present value of the actual cash flows generated by the investment equals the bond's price at the time of sale of the bond. D) All of the above are true. Ans: B

8-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 54. Jenny LePlaz is looking to invest in a five-year bond that pays annual coupons of 6.25 percent and currently sells at $912.34. What is the current market yield on such bonds? (Round to the closest answer.) A) 9.5% B) 8.5% C) 6.5% D) 7.5% Ans: B Feedback: Years to maturity = n = 5 Coupon rate = C = 6.25% Annual coupon = $1,000 × (0.0625) = $62.50 Yield to maturity = i Present value of bond = PB = $912.34 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 8%:

𝑃𝐵 = C(𝑃𝑉𝐼𝐹𝐴𝑖,𝑛 ) + F(𝑃𝑉𝐼𝐹𝑖,𝑛 ) $912.34 = $62.50 * [

1−

1 (1+0.08)5

0.08

$1,000

] + (1.08)5

= $249.54 + 680.58 ≠ $930.12 Try a higher rate, say YTM = 8.5%:

𝑃𝐵 = C(𝑃𝑉𝐼𝐹𝐴𝑖,𝑛 ) + F(𝑃𝑉𝐼𝐹𝑖,𝑛 ) $912.34 = $62.50 * [

1−

1 (1+0.085)5

0.085

$1,000

] + (1.085)5

≅ $246.29 + 665.05 ≅ $911.33 The YTM is approximately 8.5 percent. Using a financial calculator provided an exact YTM of 8.47 percent. N = 5 PMT = $62.50 PV = –$912.34 CPT I/Y gives the interest rate as 8.47 percent.

FV = $1,000

8-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 55. Nathan Akpan is planning to invest in a seven-year bond that pays annual coupons at a rate of 7 percent. It is currently selling at $927.23. What is the current market yield on such bonds? (Round to the closest answer.) A) 10.4% B) 9.5% C) 8.4% D) 7.5% Ans: C Feedback: Years to maturity = n = 7 Coupon rate = C = 7% Annual coupon = $1,000 × (0.07) = $70 Yield to maturity = i Present value of bond = PB = $927.23 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 8%:

𝑃𝐵 = C(𝑃𝑉𝐼𝐹𝐴𝑖,𝑛 ) + F(𝑃𝑉𝐼𝐹𝑖,𝑛 ) 1

$927.23 = $70 * [

1− (1+0.08)7 0.08

$1,000

] + (1.08)7

= $364.45 + 583.49 ≠ $947.94 Try a higher rate, say YTM = 8.5%:

𝑃𝐵 = C(𝑃𝑉𝐼𝐹𝐴𝑖,𝑛 ) + F(𝑃𝑉𝐼𝐹𝑖,𝑛 ) 1

$927.23 = $70 * [

1− (1+0.085)7 0.085

$1,000

] + (1.085)7

= $358.30 + 564.93 = $923.22 Try a lower rate, say YTM = 8.4%: The YTM is approximately 8.4 percent. Using a financial calculator provided an exact YTM of 8.42 percent. N = 7 PMT = $70

PV = –$927.23

FV = $1,000

CPT I/Y gives the interest rate as 8.42 percent.

8-30

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 56. Jane Almeda is interested in a 10-year bond issued by Roberts Corp. that pays a coupon of 10 percent annually. The current price of this bond is $1,174.45. What is the yield that Jane would earn by buying it at this price and holding it to maturity? (Round to the closest answer.) A) 7.1% B) 7.5% C) 8.9% D) 8.5% Ans: B Feedback: Years to maturity = n = 10 Coupon rate = C = 10% Annual coupon = $1,000 × (0.10) = $100 Yield to maturity = i Present value of bond = PB = $1,174.45 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a premium, we know that the yield to maturity is lower than the coupon rate. Try YTM = 8%:

𝑃𝐵 = C(𝑃𝑉𝐼𝐹𝐴𝑖,𝑛 ) + F(𝑃𝑉𝐼𝐹𝑖,𝑛 ) 1

$1,174.45 = $100 * [

1− (1+0.08)10 0.08

$1,000

] + (1.08)10

= $671.01 + 463.19 ≠ $1,134.20 Try a lower rate, say YTM = 7.5%: 𝑃𝐵 = 𝐶(𝑃𝑉𝐼𝐹𝐴𝑖,𝑛 ) + 𝐹(𝑃𝑉𝐼𝐹𝑖,𝑛 ) 1

1− (1+0.075)10

$1,174.45 = $100 ∗ [

0.075

$1,000

] + (1.075)10

= $686.41 + 485.19 ≅ $1,171.60 The YTM is approximately 7.5 percent. Using a financial calculator provided an exact YTM of 7.46 percent. N = 10 PMT = $100 PV = −$1,174.45 FV = $1,000 CPT I/Y gives the interest rate as 7.46 percent.

8-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 57. Shawna Carter wants to invest her recent bonus in a four-year bond that pays a coupon of 11 percent semiannually. The bonds are selling at $962.13 today. If she buys this bond and holds it to maturity, what would be her yield? (Round to the closest answer.) A) 11.5% B) 11.8% C) 12.5% D) 12.2% Ans: D Feedback: Years to maturity = n = 4 Coupon rate = C = 11% Semiannual coupon = $1,000 × (0.11/2) = $55 Yield to maturity = i Present value of bond = PB = $962.13 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 12%:

1   1   2n  1 − 1 − i 1 +  (1.06)8  $1, 000  F 2 + $962.13 = C   = $55   +  2n 2 i 0.06 (1.06)8 i     1 + 2 2       = $341.54 + $627.41  $968.95

(

)

(

)

Try a higher rate, say YTM = 12.2%:

1   1   2n  1 − 1− i 8 1 +   F (1.061)  $1, 000 2 + $962.13 = C   = $55   +  2n 8 2 i 0.061 i   (1.061)   1+ 2 2       = $340.19 + $622.70  $962.89

(

)

(

)

The YTM is approximately 12.2 percent. Using a financial calculator provided an exact YTM of 12.22 percent (2 × 6.11%). N=8 PMT = $55 PV = −$962.13 FV = $1,000 CPT I/Y gives the semiannual interest rate as 6.11 percent.

8-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 58. Alice Trang is planning to buy a six-year bond that pays a coupon of 10 percent semiannually. Given the current price of $878.21, what is the yield to maturity on these bonds? (Round to the closest answer.) A) 11% B) 12% C) 13% D) 14% Ans: C Feedback: Years to maturity = n = 6 Coupon rate = C = 10% Semiannual coupon = $1,000 × (0.10/2) = $50.00 Yield to maturity = i Present value of bond = PB = $878.21 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 12%:

1   1   2n  1 − 1 − i 1 +  (1.06)12  $1, 000  F 2 + $878.21 = C   = $50   +  2n 2 i 0.06 (1.06)12 i     1 + 2 2       = $419.19 + $496.97  $916.16

(

)

(

)

Try a higher rate, say YTM = 13%:

1   1   2n  1 − 1− i 12 1 +   F (1.065)  $1, 000 2 + $878.21 = C   = $50   +  2n 12 2 i 0.065 i   (1.065)   1+ 2 2       = $407.94 + $469.68  $877.62

(

)

(

)

The YTM is approximately 13 percent. Using a financial calculator provided an exact YTM of 12.98 percent (2 × 6.49%). N = 12 PMT = $50 PV = −$878.21 FV = $1,000 CPT I/Y gives the semiannual interest rate as 6.49 percent.

8-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 59. John Wong purchased a five-year bond today at $1,034.66. The bond pays 6.5 percent semiannually. What will be his yield to maturity? (Round to the closest answer.) A) 6.7% B) 6.2% C) 3.25% D) 5.7% Ans: D Feedback: Years to maturity = n = 5 Coupon rate = C = 6.5% Semiannual coupon = $1,000 × (0.065/2) = $32.50 Yield to maturity = i Present value of bond = PB = $1,034.66 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a premium, we know that the yield to maturity is lower than the coupon rate. Try YTM = 6%:

1   1   2n  1 − 1− i 1 +   F (1.03)10  $1, 000 2 + $1, 034.66 = C   = $32.50   +  2n 10 2 i 0.03 i   (1.03)   1+ 2 2       = $277.23 + $744.09  $1, 021.33

(

)

(

)

Try a lower rate, say YTM = 5.7%:

1   1 − 1   2n   1− 10  1+ i    F $1, 000 (1.0285) 2 $1, 034.66 = C   + = $32.50   +  2n 10 2 i  0.0285  (1.0285)   1+ i 2 2       = $279.37 + $755.02  $1, 034.38

(

)

(

)

The YTM is approximately 5.7 percent. Using a financial calculator provided an exact YTM of 5.69 percent (2 × 2.847%). N = 10 PMT = 32.50 PV = −$1,034.66 FV = $1,000 CPT I/Y gives the semiannual interest rate as 2.847 percent.

8-34

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 60. Huan Zhang bought a 10-year bond that pays 8.25 percent semiannually for $911.10. What is the yield to maturity on this bond? (Round your percentage answer to two decimal places.) A) 7.60% B) 8.68% C) 9.66% D) 10.67% Ans: C Feedback: Years to maturity = n = 10 Coupon rate = C = 8.25% Semiannual coupon = $1,000 × (0.0825/2) = $41.25 Yield to maturity = i Present value of bond = PB = $911.10 Use the trial-and-error approach to solve for YTM. Since the bond is selling at a discount, we know that the yield to maturity is higher than the coupon rate. Try YTM = 9.4%:

1   1   2n  1 − 1− i 20  1 +    F $1, 000 (1.047) 2 $911.10 = C   + = $41.25   +   2 n 20 2 i  0.047  (1.047)   1+ i 2 2       = $527.40 + $399.09  $926.48

(

)

(

)

Try a higher rate, say YTM = 9.6%: 1−

$911.1 = 𝐶⁄2 × [

1 (1+ 𝑖⁄2)

𝑖⁄ 2

2𝑛

] +

𝐹 2𝑛

(1+ 𝑖⁄2)

= $41.25 × [

1− (1.048)20 0.048

$1,000

] + (1.048)20

= 522.90 + $391.54 ≈ $𝟗𝟏𝟒. 𝟒𝟑 The YTM is approximately 9.66 percent. Using a financial calculator provided an exact YTM of 9.656 percent (2 × 4.828%). N = 20 PMT = $41.25 PV = −$911.10 FV = $1,000 CPT I/Y gives the semiannual interest rate as 4.828 percent.

8-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 61. Five years ago, Shirley Harper bought a 10-year bond that pays 8 percent semiannually for $981.10. Today, she sold it for $1,067.22. What is the realized yield on her investment? (Round to the nearest percent.) A) 7% B) 8% C) 11% D) 10% Ans: D Feedback:

8-36

Fundamentals of Corporate Finance 3e

Test Bank

Purchase price of bond = $981.10 Years investment held = n = 5 Coupon rate = C = 8% Frequency of payment = m = 2 Semiannual coupon = $1,000 × (0.08/2) = $40 Realized Yield = i Selling price of bond = PB = $1,067.22 To compute the realized return, either the trial-and-error approach or the financial calculator can be used. Since the price has increased, market rates must have decreased. So, the realized return is going to be greater than the bond's coupon. Try rates higher than the coupon rate. Try i = 10%, or i/2 = 5%:

1   1 − (1 + i ) mn  C FV + 2 PB =     i 2 (1 + i ) mn 2 2     1   1 − (1.05)10  $1, 067.22 $981.10 = $40   + (1.05)10  0.05    = $308.87 + $655.18  $964.05 Try a lower rate, i = 9.6% or i/2 = 4.8%:

1   1 − (1 + i ) mn  C FV + 2 PB =     i 2 (1 + i ) mn 2 2     1   1 − (1.048)10  $1, 067.22 $981.10 = $40   + 10  0.048  (1.048)   = $311.89 + $667.79  $979.68 The realized rate of return is approximately 9.6 percent rounded to 10%. Using a financial calculator provided an exact yield of 9.56 percent.

8-37

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 62. Rachel McGovern bought a 10-year bond for $921.77 seven years ago. The bond pays a coupon of 15 percent semiannually. Today, the bond is priced at $961.22. If she sold the bond today, what would be her realized yield? (Round to the nearest percent.) A) 17% B) 18% C) 9% D) 10% Ans: A Feedback:

8-38

Fundamentals of Corporate Finance 3e

Test Bank

Purchase price of bond = $921.77 Years investment held = n = 7 Coupon rate = C = 15% Frequency of payment = m = 2 Annual coupon = $1,000 × (0. 15/2) = $75.00 Realized Yield = i Selling price of bond = PB = $961.22 To compute the realized return, either the trial-and-error approach or the financial calculator can be used. Since the price has increased, market rates must have decreased. So, the realized return is going to be greater than the bond's coupon. Try rates higher than the coupon rate. Try i = 17%, or i/2 = 8.5%: 1   1 − (1 + i ) mn  C FV + 2 PB =     i 2 (1 + i ) mn 2 2     1   1 − (1.085)14  $961.22 $921.77 = $75   + 14  0.085  (1.085)  

= $600.76 + $306.77  $907.52 Try a lower rate, i = 16.6% or i/2 = 8.3%:

1   1 − (1 + i ) mn  C FV + 2 PB =    (1 + i ) mn i 2  2 2     1   1 − (1.083)14  $961.22 $921.77 = $75   + 14  0.083  (1.083)   = $607.69 + $314.79  $922.50 The realized rate of return is approximately 16.6 percent. Using a financial calculator provided an exact yield of 16.625 percent. Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 63. Jorge Cabrera paid $980 for a 15-year bond 10 years ago. The bond pays a coupon of 10 percent semiannually. Today, the bond is priced at $1,054.36. If he sells the bond today, what will be his realized yield? (Round to the nearest percent.)

8-39

Fundamentals of Corporate Finance 3e

Test Bank

A) 12% B) 8% C) 11% D) 9% Ans: C Feedback: Purchase price of bond = $980 Years investment held = n = 10 Coupon rate = C = 10% Frequency of payment = m = 2 Annual coupon = $1,000 × (0. 10/2) = $50.00 Realized Yield = i Selling price of bond = PB = $1,054.36 To compute the realized return, either the trial-and-error approach or the financial calculator can be used. Since the price has increased, market rates must have decreased. So, the realized return is going to be greater than the bond's coupon. Try rates higher than the coupon rate. Try i = 10.5%, or i/2 = 5.25%:

1   1 − (1 + i ) mn  C FV + 2 PB =     i 2 (1 + i ) mn 2 2     1   1 − (1.0525) 20  $1, 054.36 $980 = $50   + 20  0.0525  (1.0525)   = $610.11 + $378.92  $989.03 Try a higher rate, i = 10.7% or i/2 = 5.35%: 1−

𝑃𝐵 =

C 2

× [

1 (1+ 𝑖⁄2)

𝑚𝑥𝑛

𝑖⁄ 2

𝐹𝑉 𝑚𝑥𝑛 (1+ 𝑖⁄2)

$908 = $50 [

1− (1.0535)20 0.0535

$1,054.36

] + (1.0535)20

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

8-40

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 64. Suppose an investor earned a semiannual yield of 6.4 percent on a bond paying coupons twice a year. What is the effective annual yield (EAY) on this investment? (Round to two decimal places.) A) 12.80% B) 6.40% C) 6.50% D) 13.21%. Ans: D Feedback: Semiannual yield = 6.4% The effective annual yield can be computed as:

EAY = (1 +

0.128 2 ) −1 2

= 13.21%

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 65. Which of the following statements is true? A) Long-term bonds have lower price volatility than short-term bonds of similar risk. B) As interest rates decline, the prices of bonds rise; and as interest rates rise, the prices of bonds decline. C) All other things being equal, short-term bonds are riskier than long-term bonds. D) Interest rate risk decreases as maturity increases. Ans: B

8-41

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 66. Which one of the following statements is NOT true? A) Interest rate risk is the risk that bond prices will change as interest rates change. B) Interest rate changes and bond prices are inversely related. C) As interest rates increase, bond prices increase. D) Long-term bonds are more price volatile than short-term bonds of similar risk. Ans C :

Format: Multiple Choice Learning Objective: LO 4, LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 67. Which of the following statements is true? A) The longer the maturity of a security, the greater its interest rate risk. B) If investors believe inflation will be subsiding in the future, the prevailing yield will be upward sloping. C) The real rate of interest varies with the business cycle, with the lowest rates seen at the end of a period of business expansion and the highest at the bottom of a recession. D) The interest rate risk premium always adds a downward bias to the slope of the yield curve. Ans A :

8-42

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 68. Which of the following statements is true? A) For a given change in market interest rates, the prices of higher-coupon bonds change more than the prices of lower-coupon bonds. B) If market interest rates rise, a 1-year bond will fall in value more than a 10-year bond. C) If interest rates rise, bond prices will rise. D) If market interest rates rise, a 10-year bond will fall in value more than a 1-year bond. Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 69. Stanley Hart invested in a municipal bond that promised an annual yield of 6.7 percent. The bond pays coupons twice a year. What is the effective annual yield (EAY) on this investment? (Round percentage to two decimal places.) A) 13.4% B) 6.81% C) 6.70% D) None of the above Ans: B Feedback: Annual yield = 6.7% The effective annual yield can be computed as:

EAY = 0.06812 or 6.81%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 70. Marketability is the ability of an investor A) to sell a security quickly, at a low transaction cost, and at a price close to its fair market value. B) to sell at a profit under all circumstances. C) to sell the security above its par value. D) None of the above Ans: A

71.

72.

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement Which of the following statements is true? A) The lower the transaction costs are, the greater a security's marketability. B) The interest rate, or yield, on a security varies with its degree of marketability. C) U.S. Treasury bills have the largest and most active secondary market and are considered to be the most marketable of all securities. D) All of the above are true. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement Which of the following statements is NOT true? A) The risk that the lender may not receive payments as promised is called default risk. B) Investors must pay a premium to purchase a security that exposes them to default risk. C) U.S. Treasury securities are the best proxy measure for the risk-free rate. D) All of the above are true statements. Ans: B

Format: Multiple Choice Learning Objective: LO 6

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73.

74.

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Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement Downward-slopping yield curves are observed A) when the economy is growing. B) when the economy is stagnant. C) before the beginning of a recession. None of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement Which one of the following statements is NOT true? A) The relationship between yield to maturity and marketability is known as the term structure of interest rates. B) The shape of the yield curve is not constant over time. C) As the general level of interest rises and falls over time, the yield curve shifts up and down and has different slopes. D) Yield curves show graphically how market yields vary as term to maturity changes. Ans: A

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 75. The three economic factors that affect the shape of the yield curve are: A) the real rate of interest, the expected rate of inflation, and marketability. B) the real rate of interest, the expected rate of inflation, and interest rate risk. C) the nominal rate of interest, the expected rate of inflation, and default risk. D) the real rate of interest, the nominal rate of interest, and currency risk. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 76. Which of the following statements is true? A) Investment grade bonds are those rated single B and higher. B) Federal laws typically allow insurance companies and pension funds to purchase noninvestment grade bonds. C) Because investors are risk averse, they require a premium to purchase a security that exposes them to default risk. D) All else equal, the higher a bond’s rating the higher the coupon rate. Ans: C

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 77. Which of the following statements is true? A) Downward sloping yield curves typically appear in the early to mid-period of a business expansion. B) Interest rate risk premium always adds an upward bias to the slope of the yield curve. C) If investors believe that inflation will be increasing in the near future, the yield curve will be downward sloping. D) Downward-sloping yield curve is the yield curve most commonly observed. Ans: B

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 78. What is the marketability risk premium? Why should an issuing firm consider paying this premium? Ans: Marketability is the ability of an investor to sell a security quickly at a low transaction cost and at its fair market value. The difference in interest rates or yields between the most marketable security and a less marketable security is known as the marketability risk premium. Investors would prefer more marketable securities. Investors prefer securities that can be easily converted to cash without a loss in value. The lower the marketability of a particular bond, the higher the compensation that would be demanded by investors. In order for investors to buy securities that are less marketable, issuing companies have to pay a marketability risk premium (MRP).

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 79. Why does the default risk premium vary over the business cycle? Ans: Default risk premiums vary over the business cycle. Larger premiums are required during recessionary times, while economic expansions reduce such premiums. During periods of economic expansion, investors are willing to hold bonds with low credit ratings in their portfolios because there is little chance of default and these bonds normally have higher yields. During such times, investors tend to seek out the highestyielding investments. On the other hand, during a recession, the prime concern of investors becomes safety. We call this the flight to quality. Since firms have a higher probability of failing during an economic downturn, investors are more concerned about default risk and will demand a higher default risk premium.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 80. What economic factors affect the level and the shape of the yield curve? Explain. Ans: Three economic factors affect the shape of the yield curve: (1) the real rate of interest; (2) the expected rate of inflation; and (3) the interest rate risk. As an economy grows, the real rate of interest will increase, causing the yield curve to have an upward slope. Similarly, if investors think that inflation will increase in the future, they will require a higher inflation premium, again forcing an upward tilt to the yield curve. Since the observed or nominal interest rate is a combination of these two factors, the slope of the yield curve will shift upward. The opposite will happen during an economic downturn. The third factor, the interest rate risk, will cause longer term securities to have a higher yield than shorter term securities, again giving the yield curve an upward bias.

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Chapter 9: Stock Valuation Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. Equity securities are certificates of ownership of a corporation. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 2. The stocks owned by households represent about 35% of the total value of all corporate equity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 3. A large number of investors in equities actually own through pension or retirement funds. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 4. A) B) .

Companies raise capital in secondary markets by issuing new securities. True False 9-1

Fundamentals of Corporate Finance 3e

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Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 5.

An active secondary market for debt or equity securities makes raising new capital less expensive for firms. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 6.

For investors, the function of secondary markets is to provide marketability for the securities they own at a fair price. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7.

Secondary market transactions in the United States mostly take place over the counter and not in exchanges. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance .

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Fundamentals of Corporate Finance 3e

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AICPA: Industry/Sector Perspective 8.

In terms of market capitalization (total stock value) of the firms listed, the NYSE is the largest in the world and NASDAQ is the second largest. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. Direct search markets provide the best price information. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. Direct search is the least efficient type of secondary market. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11.

For a commission fee less than the cost of direct search, brokers give investors an incentive to make use of the information by hiring them. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy .

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Fundamentals of Corporate Finance 3e

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Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12.

A broker market eliminates the need for time-consuming search for a fair deal by buying and selling immediately from its inventory of securities. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. NASDAQ is the best-known example of a direct market. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 14. In an auction market, buyers and sellers confront each other directly and bargain over price. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15. The New York Stock Exchange is the best-known example of an auction market. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. The common stockholders of a company have unlimited liability. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 17.

Preferred stockholders are not guaranteed any dividend payments and have the lowest-priority claim on the firm’s assets in the event of bankruptcy. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 18.

Preferred dividend payments are fixed obligations of the firm, similar to the interest payments on corporate bonds. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 19. A) .

The market considers preferred stock to be a debt security because the dividend payment is a fixed contractual obligation and has credit ratings like bonds. True 9-5

Fundamentals of Corporate Finance 3e

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B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 20.

Valuation of common and preferred stock is done using a different valuation formula than that used for bonds. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 21.

In the general dividend-valuation model, the price of a share of stock is the present value of all expected future dividends. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 22. For a company that has no growth, dividends stay constant over time. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance .

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Fundamentals of Corporate Finance 3e

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AICPA: Measurement 23. A fast growing company will pay constant dividends over a period of time. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 24. The constant-growth stock has dividends growing at a constant rate over time. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 25.

The constant-growth dividend model tells us that the current price of a share of stock is the next period dividend divided by the difference between the discount rate and the dividend growth rate. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 26.

Whenever the constant-growth rate for dividends exceeds the required rate of return on the common stock, the constant-growth model provides invalid solutions. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium .

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Fundamentals of Corporate Finance 3e

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Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 27.

The value of a supernormal growth stock is the present value of the mixed growth dividend payments and the present value of the constant-growth dividend payments. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. Failure to pay a preferred dividend signals to the market that the firm is in serious financial trouble. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 29. Preferred stock with no fixed maturity can be valued as a perpetuity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 30. The bond valuation model can be used to value perpetual preferred stocks. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 31. The stocks owned by ––––– represent about 35 percent of the total value of all corporate equity. A) mutual funds. B) pension funds. C) foreign investors. D) households. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 32.

Which of the following statements is true about secondary markets? In secondary markets, outstanding shares of stock are bought and sold among investors. Most secondary market transactions directly affect the capital of the firm that issues the securities. An active secondary market causes firms to sell their new debt or equity issues at a higher transaction cost of funds. D) All of the above statements are true Ans: A

A) B) C)

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 33.

Which of the following statements is true about secondary markets in the United States? In terms of market capitalization (total stock value) of the firms listed, the NASDAQ is the largest in the world and the NYSE is the second largest. B) NASDAQ is an OTC (over-the-counter) market. C) Firms listed on the NASDAQ tend to be, on average, larger in size, and their shares trade more frequently than those traded on NYSE. D) In the United States, most secondary market transactions are done over the counter. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy .

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Fundamentals of Corporate Finance 3e

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Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34.

Which of the following statements is NOT true about secondary markets? In terms of market capitalization (total stock value) of the firms listed, the NASDAQ is the largest in the world and the NYSE is the second largest. B) NASDAQ is the second-largest stock market in the United States. C) Firms listed on the NYSE tend to be, on average, larger in size and their shares trade more frequently than those traded on NASDAQ. D) In the United States, most secondary market transactions are done on one of the many stock exchanges. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35.

In comparison to the NYSE, NASDAQ has less company listed. total share volume is lower on the NASDAQ. firms listed on the NASDAQ tend to be smaller. NASDAQ firms exceed NYSE listed firms in total capitalization. Ans: C

A) B) C) D)

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36.

Direct search markets are characterized by: A) complete price information. B) extensive broker and dealer participation. C) private placement transactions and sale of common stock of small private companies. D) a high level of efficiency. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic .

9-10

Fundamentals of Corporate Finance 3e

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IMA: Corporate Finance AICPA: Industry/Sector Perspective 37.

The least efficient of all the different types of secondary markets is the: auction market. direct search market. dealer market. broker market. Ans: B

A) B) C) D)

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. A) B)

Which of the following statements is NOT true about broker markets? Brokers bring buyers and sellers together to earn a fee, called a commission. Brokers’ extensive contacts provide them with a pool of price information that individual investors could not economically duplicate themselves. C) Investors have an incentive to hire a broker because what they charge as a commission is less than the cost of direct search. D) Brokers can guarantee an order because they have an inventory of securities. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39.

In brokered markets: A) the commission charged by brokers is a lower cost to buyers and sellers than the cost of direct search. B) buyers and sellers are brought together for a commission. C) brokers build a pool of price information through their extensive contacts. D) All of the above are true of broker markets. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. .

Which of the following statements is true about dealer markets? 9-11

Fundamentals of Corporate Finance 3e

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A) B) C)

NYSE is the best-known example of a dealer market. A dealer market involves time-consuming search for a fair deal. The advantage of a dealer over a brokered market is that brokers cannot guarantee that an order will be executed promptly, while dealers can, because they have an inventory of securities. D) All of the above are true of dealer markets. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41.

Dealer markets are characterized by: no time-consuming search for a fair deal. a guarantee of order fulfillment because the dealer holds an inventory of securities. improved market efficiency because dealers provide continuous bid and ask prices for securities. All of the above characterize dealer markets. Ans: D

A) B) C) D)

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42.

Which of the following statements is NOT true about auction markets?

A) B) C) D)

In an auction market, buyers and sellers confront each other directly and bargain over price. The participants can only communicate orally in auction markets. The New York Stock Exchange is the best-known example of an auction market. The auctioneer in an auction market is the specialist, who is designated by the exchange to represent orders placed by public customers. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 43.

A) B) .

Which of the following statements is NOT true about common stock? Common-stock holders have the right to vote on the election of the board of directors of their company. Common stock is considered to have no fixed maturity. 9-12

Fundamentals of Corporate Finance 3e

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C) D)

Owners of common stock are guaranteed dividend payments by the firm. Common-stock holders have limited liability toward the obligations of the corporation. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 44.

Which of the following statements is true about common stock? Common stock is considered to have a fixed maturity. Owners of common stock are guaranteed dividend payment by the firm. Owners of common stock have the lowest-priority claim on the firm’s assets in the event of bankruptcy. D) Common-stock holders have unlimited liability toward the obligations of the corporation. Ans: C

A) B) C)

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. A

Which of the following is NOT a widely known stock market index? The Dow Jones Industrial Average ) B The OTQ Composite Index ) C The New York Stock Exchange Index ) D) The Standard and Poor’s 500 Index Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 46.

A) B) C) D) .

Which of the following statements is NOT true about preferred stock? Preferred stock represents ownership in the firm. Preferred stockholders are not eligible for guaranteed dividend payments by the firm. Preferred stock dividends are paid by the issuer with after-tax dollars. Preferred stock holders have limited voting privileges relative to common-stock owners. 9-13

Fundamentals of Corporate Finance 3e

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Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 47.

Which of the following statements is NOT true about preferred stock? Preferred dividend payments are paid by the issuer with after-tax dollars. Preferred dividends are tax deductible just like the interest on bonds. Preferred stock holders have limited voting privileges relative to common-stock owners. Preferred stocks are generally viewed as perpetuities because they have no fixed maturity. Ans: B

A) B) C) D)

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 48.

Owners of preferred stock: A) have limited voting rights. B) usually receive fixed dividend payments. C) are given priority treatment over common stock with respect to dividends payments, and the claims against the firm’s assets in the event of bankruptcy or liquidation. D) All of the above statements are true. Ans: D Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 49.

Preferred stock is sometimes treated like a debt security because: legally preferred stock is a debt security. preferred dividend payments are similar to bond interest payments and are fixed in nature regardless of the firm’s earnings. C) preferred dividends are deductible from taxable income just like interest payments on bonds. D) preferred stock holders receive a residual value and not a stated value. Ans: B

A) B)

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 50. A) B) C) D) Ans

Which of the following statements is true? Preferred stockholders are considered to be the true owners of public corporations. Dividends paid to preferred stockholders are not fixed. Preferred stockholders do not typically have voting rights. Preferred stock can never be converted to common stock. C :

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 51.

Applying the valuation procedure to common stocks is more difficult than applying it to bonds because: A) the size and timing of the dividend cash flows are less certain than the coupon payments for bonds. B) common stocks have no final maturity date. C) unlike the rate of return, or yield, on bonds, the rate of return on common stock is not directly observable. D) All of the above are true. Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 52.

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

P0 =

D1 + P1 $4.50 + $85.00 $89.50 = = = $77.82 1+ R 1 + 0.15 1.15

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 53.

Which of the following statements is NOT true about the general dividend valuation model? A) The model does not assume any specific pattern for future dividends, such as a constant growth rate. B) It makes a specific assumption about when the share of stock is going to be sold in the future. C) The model calls for forecasting an infinite number of dividends for a stock. D) The price of a share of stock is the present value of all expected future dividends. Ans: B

9-16

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 54.

Which of the following statements is true about the general dividend valuation model? A) It implies that the underlying value of a share of stock is determined by the market’s expectations of the future dividends that the firm will generate. B) It implies that the value of a firm’s common stock can be determined only if the expected future dividends are infinite. C) It implies that the value of a growth stock can be determined by forecasting the future price of the stock. D) The model cannot be used to calculate the value of a common stock unless the dividends exceed the firm’s expected growth rate. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 55.

Which of the following statements is true about growth stocks? These are stocks of firms that grow their sales at above-average rates and are expected to do so for a length of time. B) These are stocks of firms that grow their earnings at above-average rates and are expected to do so for a length of time. C) They generally pay dividends during their fast growth phase. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 56.

A) B) C) .

Which of the following are the three simplifying assumptions that cover most stock growth patterns? Dividends remain constant over time, dividends grow at a constant rate, and dividends are equal to zero. Dividends have a zero-growth rate, dividends grow at a varying rate, and dividends are equal to zero. Dividends remain constant over time, dividends grow at a constant rate, and dividends have a mixed growth pattern. 9-17

Fundamentals of Corporate Finance 3e

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None of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 57.

Which of the following statements is NOT true about zero-growth stocks? A) Dividend payment pattern remains constant over time. B) The cash flow pattern resembles a perpetuity with a constant cash flow. C) Dividend pattern for common stock of a company shows growth over time. D) There is no growth in dividends over time. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 58.

Which of the following statements is NOT true about constant-growth stocks? Cash dividend remains constant over time. Mature companies with a history of stable growth show this pattern. Dividends grow at a constant rate from one period to the next forever. Far distant-dividends have a very small present value and add little to the stock’s price. Ans: A

A) B) C) D)

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 59.

The constant-growth dividend model will provide invalid solutions when: A) the growth rate of the stock exceeds the required rate of return for the stock. B) the growth rate of the stock is less than the required rate of return for the stock. C) the growth rate of the stock is equal to the risk-free rate. D) None of the above. Ans: A

9-18

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 60.

Cortez, Inc., is expecting to pay out a dividend of $2.50 next year. After that it expects its dividend to grow at 7 percent for the next four years. What is the present value of dividends over the next five-year period if the required rate of return is 10 percent? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $10.76 B) $9.80 C) $11.88 D) $11.50 Ans: A Feedback: Expected dividends for Cortez, Inc., and their present value: D2 = D1(1 + g) = $2.50(1 + 0.07) = $2.675 D3 = D2(1 + g) = $2.675(1.07) = $2.862 D4 = D3(1 + g) = $2.862(1.07) = $3.063 D5 = D4(1 + g) = $3.063(1.07) = $3.277 Present value of the dividends = PV(D1) + PV(D2) + PV(D3) + PV(D4) + PV(D5)

$2.50 $2.675 $2.862 $3.063 $3.277 + + + + (1.10) (1.10) 2 (1.10) 3 (1.10) 4 (1.10) 5 = $2.27 + $2.21 + $2.15 + $2.09 + $2.03 = $10.76

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 61.

Next year Jenkins Traders will pay a dividend of $3.00. It expects to increase its dividend by $0.25 in each of the following three years. If their required rate of return is 14 percent, what is the present value of their dividends over the next four years? (Do not round intermediate calculations. Round final answer to two decimal places) A) $13.50 B) $9.72 C) $12.50 D) $11.63 Ans: B Feedback: Expected dividends for Jenkins Traders and their present value: D1 = $3.00; D2 = $3.25; D3 = $3.50; D4 = $3.75 Present value of the dividends = PV(D1) + PV(D2) + PV(D3) + PV(D4) .

9-19

Fundamentals of Corporate Finance 3e

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$3.00 $3.25 $3.50 $3.75 + + + 2 3 (1.14) (1.14) (1.14) (1.14) 4 = $2.63 + $2.50 + $2.36 + $2.22 = $9.72

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 62.

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

$4.00 $4.40 $4.84 + + 4 5 (1.15) (1.15) (1.15)6 = $0 + $0 + $0 + 2.29 + $2.19 + $2.09 = $6.57

= $0 + $0 + $0 +

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 63.

Givens, Inc., is a fast growing technology company that paid a $1.25 dividend last week. The company’s expected dividend growth rates over the next four years are as follows: 25 percent, 30 percent 35 percent, and 30 percent. The company then expects to settle down to a constant-growth rate of 8 percent annually. If the required rate of return is 12 percent, what is the present value of 9-20

Fundamentals of Corporate Finance 3e

Test Bank

the dividends over the fast growth phase? (Do not round intermediate calculations. Round final answer to two decimal places.)

A) B) C) D)

$1.25 $6.46 $8.37 $7.23 Ans: D Feedback: Expected dividends for Givens, Inc., and their present value: D0 = $1.25 D1 = D0(1 + g) = $1.25(1.25) = $1.563 D2 = D1(1 + g) = $1.563(1.30) = $2.031 D3 = D2(1 + g) = $2.031(1.35) = $2.742 D4 = D3(1 + g) = $2.742(1.30) = $3.565 Present value of the dividends = PV(D1) + PV(D2) + PV(D3) + PV(D4)

$1.563 $2.031 $2.742 $3.565 + + + (1.12) (1.12) 2 (1.12) 3 (1.12) 4 = $1.40 + $1.62 + $1.95 + $2.27 = $7.23

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 64.

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

$2.50 $3.00 $3.00 + + 3 4 (1.15) (1.15) (1.15)5 = $0 + $0 + $1.64 + $1.72 + $1.49 = $4.85

= $0 + $0 +

9-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 65.

Xinhua Manufacturing Company has been generating stable revenues but sees no growth in it for the foreseeable future. The company’s last dividend was $3.25, and it is unlikely to change the amount paid out. If the required rate of return is 12 percent, what is the stock worth today? (Round the final answer to two decimal places.) A) $39.00 B) $3.69 C) $27.08 D) $21.23 Ans: C Feedback: D0 = $3.25; g = 0; R = 12%

P0 =

D $3.25 = = $27.08 R 0.12

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 66.

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

P0 =

D $4.50 = = $50.00 R 0.09

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance .

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Fundamentals of Corporate Finance 3e

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AICPA: Measurement 67.

Metasteel Limited Co. has a stable sales track record, but does not expect to grow in the next several years. Its last annual dividend was $5.75. If the required rate of return on similar investments is 18 percent, what is the current stock price? (Round the answer to two decimal places.) A) $103.50 B) $13.50 C) $39.30 D) $31.94 Ans: D Feedback: D0 = $5.75; g = 0; R = 18%

P0 =

D $5.75 = = $31.94 R 0.18

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 68.

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

D D0 = = $46.88 R 0.16 D0 = $46.88  0.16 = $7.50 P0 =

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 69.

A communications company pays annual dividends of $8.50 with no possibility of it changing in the next several years. If the firm’s stock is currently selling at $60.71, what is the required rate of return? (Round to nearest whole number.) 9-23

Fundamentals of Corporate Finance 3e

Test Bank

A) B) C) D)

14% 16% 13% 15% Ans: A Feedback: P0 = $60.71;

g = 0; D0 = $8.50

P0 = $60.71 = R=

D $8.50 = R R

$8.50 = 14% $60.71

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 70.

You are interested in investing in a company that expects to grow steadily at an annual rate of 6 percent for the foreseeable future. The firm paid a dividend of $2.30 last year. If your required rate of return is 10 percent, what is the most you would be willing to pay for this stock? (Round to the nearest dollar.) A) $58 B) $61 C) $23 D) $24 Ans: B Feedback: D0 = $2.30; g = 6%; R = 10%

D (1 + g ) D1 = 0 R−g R−g $2.30(1.06) $2.438 = = = $60.95 0.10 − 0.06 0.04

P0 =

=$61.00 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 71.

A) B) .

Johnson Corporation has just paid a dividend of $4.45. The company has forecasted a growth rate of 8 percent for the next several years. If the appropriate discount rate is 14 percent, what is the current price of this stock? (Round to the nearest dollar.) $74 $32 9-24

Fundamentals of Corporate Finance 3e

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C) D)

$80 $60 Ans: C Feedback: D0 = $4.45;

g = 8%; R = 14%

D (1 + g ) D1 = 0 R−g R−g $4.45(1.08) $4.806 = = = $80.10 0.14 − 0.08 0.06

P0 =

=$80.00 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 72.

Ryder Supplies has its stock currently selling at $63.25. The company is expected to grow at a constant rate of 7 percent. If the appropriate discount rate is 17 percent, what is the expected dividend, a year from now? (Round the answer to two decimal places.) A) $4.43 B) $3.25 C) $10.75 D) $6.33 Ans: D Feedback: P0 = $63.25; g = 7%; R = 17%

D1 R−g D1 = P0 ( R − g ) P0 =

= $63.25(0.17 − 0.07) = $6.325 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 73.

A) B) C) .

Prior, Inc., is expected to grow at a constant rate of 9 percent. If the company’s next dividend is $2.75 and its current price is $37.35, what is the required rate of return on this stock? (Do not round intermediate calculations. Round final answer to the nearest percent.) 13% 16% 20% 9-25

Fundamentals of Corporate Finance 3e

Test Bank

21% Ans: B Feedback: D1 = $2.75;

P0 = $37.35;

g = 9%

D1 P0 = R−g $2.75 $37.35 = R − 0.09 $37.35( R − 0.09) = $2.75 − 3.3615 − 2.75 = −37.35R 6.1115 R= = 16.4% 37.35 Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 74.

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

D 0 (1 + g ) 4 D4 P3 = = R−g R−g =

3.00(1.08) 4 = $58.31 0.15 − 0.08

9-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 75.

Which of the following is the most typical example of a zero-growth dividend stock? A) The common stock of a firm in the biotechnology industry. B) The preferred stock of a utility company. C) The common stock of a firm in the health care industry. D) The common stock of a firm in the information technology industry. Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 76.

The constant growth dividend model would be useful to determine the value of all, but which of the following firms? A) A firm whose earnings and dividends are declining at a fairly steady rate. B) A firm whose sales, profits, and dividends are growing at an annual average compound rate of 5 percent. C) A firm whose earnings and dividends are growing at a fairly steady rate. D) A firm whose expected sales, profits, and dividends are flat. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 77.

Starskeep, Inc., is a fast growing technology company. The firm projects a rapid growth of 40 percent for the next two years and then a growth rate of 20 percent for the following two years. After that, the firm expects a constant-growth rate of 8 percent. The firm expects to pay its first dividend of $1.25 a year from now. If your required rate of return on such stocks is 20 percent, what is the current price of the stock? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $15.63 B) $4.70 C) $30.30 D) $22.68 Ans: A Feedback: .

9-27

Fundamentals of Corporate Finance 3e

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g1 = g2 = 40%, g3 = g4 = 20%, g = 8%, D1 = $1.25, R = 20% D1 = $1.25, D2 = $1.25(1.40) = $1.75, D3 = $1.75(1.20) = $2.10 D4 = $2.10(1.20) = $2.52, D5 = $2.52(1.08) = $2.722

D5 $2.722 = = $22.68 R − g 0.20 − 0.08 D3 D1 D2 D4 P4 P0 = + + + + 1 2 3 4 (1 + R ) (1 + R ) (1 + R ) (1 + R ) (1 + R ) 4 $1.25 $1.75 $2.10 ($2.52 + 22.68) P0 = + + + 2 1.20 (1.20) (1.20) 3 (1.20) 4 P0 = $1.04 + $1.22 + $1.22 + 12.15

P4 =

P0 = $15.63 Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 78.

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

D4 $4.173 = = $46.37 R − g 0.16 − 0.07 D3 P3 D1 D2 P0 = + + + 1 2 3 (1 + R) (1 + R) (1 + R) (1 + R) 3 $2.60 $3.25 ($3.90 + 46.37) P0 = + + 1.16 (1.16) 2 (1.16) 3 P0 = $2.24 + $2.42 + $32.20

P3 =

P0 = $36.86

9-28

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 79.

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

P4 =

D5 $6.875 = = $85.94 R − g 0.18 − 0.10 D3 D1 D2 D + P4 P0 = + + + 4 2 3 (1 + R ) (1 + R ) (1 + R ) (1 + R ) 4 $5.00 ($6.25 + $85.94) P0 = 0 + 0 + + (1.18) 3 (1.18) 4 P0 = $3.04 + $47.55 = $50.59

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 80.

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

P4 = .

D5 $7(1.07) = = $93.63 R − g 0.15 − 0.07 9-29

Fundamentals of Corporate Finance 3e

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D3 D1 D2 D4 P4 + + + + 2 3 4 (1 + R) (1 + R) (1 + R) (1 + R) (1 + R) 4 $4.75 $5.25 $5.75 ($7 + $93.63) P0 = + + + 2 1.15 (1.15) (1.15) 3 (1.15) 4 P0 = $4.13 + $3.97 + $3.78 + $57.53 = $69.41

P0 =

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 81.

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

P4 =

D5 $4.25 = = $30.36 R − g 0.20 − 0.06 P4 $30.36 $30.36 P0 = PV of dividends + = 0+ = = $14.64 4 (1 + R) (1.20) 4 2.0736

9-30

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 82.

Suppose a firm’s expected dividends for the next three years are as follows: D1 = $1.10, D2 = $1.20, and D3 = $1.30. After three years, the firm’s dividends are expected to grow at 5.00 percent per year. What should the current price of the firm’s stock (P0) be today if investors require a rate of return of 12.00 percent on the stock? (Do not round intermediate calculations. Round off final answer to the nearest $0.01) A) $61.30 B) $10.10 C) $16.74 D) $24.12 Ans: C Feedback:

D1 D2 D3 Dt $1.10 $1.20 $1.30 $19.50 + + + = + + + 1 2 3 t 2 (1 + R ) (1 + R ) (1 + R ) (1 + R ) 1.12 (1.12) (1.12)3 (1.12)3 P 0 = $0.98 + $0.96 + $0.93 + $13.88 = $16.74 =$16.74 P0 =

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 83.

Which of the following statements is true? A) In order for the constant growth dividend model to properly value a firm’s common stock, R must be greater than g. B) From a practical perspective, the growth rate in the constant growth dividend model must be greater than the sum of the long-term rate of inflation and the long-term real growth rate of the economy. C) In order for the constant growth dividend model to properly value a firm’s common stock, g must be greater than R. D) The constant growth dividend model can be used effectively to value the common shares of a mixed growth stock. Ans: A

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement .

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Fundamentals of Corporate Finance 3e

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84.

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

P0 =

D $5.50 = = $70.97 R 0.0775

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 85.

The National Bank of Columbia has issued perpetual preferred stock with a $100 par value. The bank pays a quarterly dividend of $1.40 on this stock. What is the current price of this preferred stock given a required rate of return of 8.5 percent? (Round off to two decimal places.) A) $23.06 B) $65.88 C) $37.57 D) $43.25 Ans: B Feedback: Quarterly dividend = $1.40 Required rate of return = R = 8.5%

P0 =

(1.40  4) = $65.88 0.085

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 86.

A) B) C) D) .

The preferred stock of Acme International is selling currently at $110.35. If your required rate of return is 9.75 percent, what is the dividend paid by this stock? (Round off to the two decimal places.) $9.75 $11.32 $10.76 $8.53 9-32

Fundamentals of Corporate Finance 3e

Test Bank

Ans: C Feedback: P0 = $110.35;

R = 9.75%

D D = R 0.0975 D = $110.35  0.0975 = $10.76

P0 = $110.35 =

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 87.

Each quarter, Transam, Inc., pays a dividend on its perpetual preferred stock. Today, the stock is selling at $83.45. If the required rate of return for such stocks is 10.5 percent, what is the quarterly dividend paid by the firm? (Do not round intermediate calculations. Round final answer to two decimal places.) A) $8.76 B) $10.50 C) $2.19 D) $2.63 Ans: C Feedback: P0 = $83.45;

R = 10.5%

D D = R 0.105 D = $83.45  0.105 = $8.76

P0 = $83.45 =

Annual dividend = $8.76, Quarterly dividend = $8.76 /4 = $2.19

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Hard

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 88.

A) B) C) .

The Columbia Consumer Products Co. has issued perpetual preferred stock with a $100 par value. The firm pays a quarterly dividend of $2.60 on this stock. What is the current price of this preferred stock given a required rate of return of 12.5 percent? $47.25 $80.00 $20.80 9-33

Fundamentals of Corporate Finance 3e

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$83.20 Ans: D Feedback: Quarterly dividend = $2.60 Required rate of return = R = 12.5%

P0 =

(2.60  4) = $83.20 0.125

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 89.

Which of the following statements about preferred stock is FALSE? A) Preferred stock has a higher-priority claim on the firm’s assets than the common stock. B) Failure to pay dividends on preferred stocks will result in a default. C) Preferred stock has a lower-priority claim on the firm’s assets than the firm’s creditors in the event of default. D) Preferred stock typically pays a fixed dividend. Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium

Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 90.

Durango Water Works has an outstanding issue of preferred stock that has a par (maturity value) of $75.00. The stock, which pays a quarterly dividend of $1.10, will be retired by the firm in 20 years. If the preferred stock is currently selling for $68.00, what is the preferred stock’s yield-to-maturity? (Round off to the nearest 0.01%) A) 6.72% B) 5.64% C) 4.28% D) 7.73% Ans: A Feedback: N = 20 × 4 = 80 PV = –$68.00 PMT = $ 1.10 FV = $75.00 Solve for i = 1.68% × 4 = 6.72%

Format: Essay .

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Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 91. Discuss the significance of an active secondary market to both issuers of securities and to investors. Ans: Most secondary market transactions do not directly affect the firm which issues the securities. The presence of a secondary market does, however, affect the issuer indirectly. Simply put, investors will pay a premium price for primary securities that have an active secondary market because most investors do not hold securities forever. Thus, the marketability provided by secondary markets is an important service to the issuers. Financial managers are well aware of the importance of secondary markets for the sale of their firm’s primary securities, and as a result, they encourage investment banking firms to establish secondary markets for their securities. The presence of an active secondary market allows firms to sell their new debt or equity issues at a lower funding cost than firms selling similar securities that have no secondary market. From an investor’s perspective, the function of secondary markets is to provide marketability for the shares of securities they own at a fair price.

Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium

Bloomcode: Analysis AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 92. How do the secondary markets for securities differ across the four types of markets? Ans: The direct search markets are the farthest from our ideal of complete price information and are those markets in which buyer and seller must seek each other out directly. Securities are bought and sold so infrequently that no third party, such as a broker or dealer, has an incentive to serve the market. The sale of common stock of small private companies and private placement transactions are good examples of direct search markets. This is the least efficient type of secondary market. In broker markets, brokers bring buyers and sellers together to earn a fee, called a commission. Brokers have extensive contacts, who provide them with a pool of price information that individual investors could not economically duplicate themselves. Investors have an incentive to make use of the information by hiring brokers because what brokers charge them as a commission is less than the cost of direct search. In dealer markets, market efficiency is improved by dealers providing continuous bidding (selling or buying) for the security with the help of an inventory of securities that they hold and use to make a profit. The advantage of a dealer over a brokered market is that brokers cannot guarantee that an order will be executed promptly, while dealers can because they have an inventory of securities. NASDAQ is the best-known example of a dealer market in the United States. In an auction market, buyers and sellers confront each other directly and bargain over price. The New York Stock Exchange is the best-known example of an auction market and is also the most efficient equity market in the United States. In the NYSE, the auction for a security takes place at a specific location on the floor of the exchange, called a post. The auctioneer in this case is the specialist, who is designated by the exchange to represent orders placed by public customers.

Format: Essay Learning Objective: LO 1 .

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Level of Difficulty: Medium

Bloomcode: Analysis AASCB: Analytic IMA: Corporate Finance AICPA: Measurement 93. Differentiate the characteristics of common and preferred stocks. Ans: Characteristic Common Stock Preferred Stock Represents basic ownership claim in a Represents ownership interest in the Ownership of firm corporation. corporation. Common stockholders can vote on all important matters that affect the The preferred stockholders have no life of the company, such as to voting privileges in those Voting rights elect the board of directors, matters affecting day-to-day approve the capital budget, or running the firm. vote on a proposed merger or acquisition. Common stockholders enjoy limited liability that is their losses are Liability of owners Limited limited to the original value of their investment in the firm. Preferred stock holders are given priority treatment over Have the lowest-priority claim on the common stockholders with Claim on assets firm’s assets in the event of respect to dividends payments bankruptcy. and the claims against the firm’s assets in the event of bankruptcy or liquidation. Owners of common stock are not Preferred dividend payments take Dividends guaranteed any dividend precedence over common payments dividends. Preferred stocks are legally classified Common stocks are perpetuities in the as perpetuities because they Maturity sense that they have no maturity. have no maturity. Although some type of preferred stock might have a maturity date.

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Chapter 10: The Fundamentals of Capital Budgeting Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 1. The goal of the capital budgeting decisions is to select capital projects that will decrease the value of the firm. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 2. Capital budgeting decisions, once made, are not easy to reverse because of the huge investments involved. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 3. The basis on which capital budgeting plans are made is a firm's three- to five-year strategic plan. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 4. Most of the information required to make capital budgeting decisions are internally generated, beginning with the sales force. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 5. All capital budgeting projects are independent projects. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 6. When two projects have cash flows that are tied to each other, the projects may be classified as independent. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 7. Projects are classified as independent when their cash flows are unrelated. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 8. When two projects are independent, accepting one project implicitly eliminates the other. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 9. When two projects are mutually exclusive, accepting one project implicitly eliminates the other. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 10. Projects that are classified as contingent could be mandatory or optional projects. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 11. All contingent projects are mandatory projects. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 12. The cost of capital is the maximum return a project can earn. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 13. Capital rationing refers to the limiting of capital resources to underperforming divisions. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 14. The net present value technique is an approach that goes against the goal of shareholder wealth maximization. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 15. The NPV method determines how much the present value of cash inflows exceeds the present value of costs. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 19. The discount rate used to determine the present value of future cash flows is the cost of capital. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 20. The payback method is a discounted cash flow technique. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 21. If the payback period for a project exceeds the firm's threshold period, then the project is accepted. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 22. The payback method is consistent with the goal of shareholder wealth maximization. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 23. The discounted payback period calculation calls for the future cash flows to be discounted by a firm's cost of capital. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 24. Unlike the regular payback method, the discounted payback method does not ignore cash flows beyond a firm's threshold period. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 25. The accounting rate of return is not a true return because it simply utilizes some average figures from a firm's balance sheet and income statement. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 26. The decision criterion for the accounting rate of return is consistent with the goal of shareholder wealth maximization. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 27. The IRR and NPV decisions are consistent with each other when a project's cash flows follow a conventional pattern. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 28. Unconventional cash flow patterns could lead to conflicting decisions by NPV and IRR. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 29. When mutually exclusive projects are considered, both NPV and IRR will always produce the same acceptance decision. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 30. When evaluating two projects that require different outlays, the IRR does not recognize the difference in the size of the investments. A) True B) False Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 31. Which of the following is NOT true about capital budgeting? A) It involves identifying projects that will add to a firm's value. B) It involves investing large capital. C) It allows a firm to reverse the decision of large capital investments at any time. D) It allows a firm's management to analyze potential business opportunities and decide on which ones to undertake. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 32. Which of the following is an aspect of independent projects? A) The cash flows are related. B) The cash flows are unrelated. C) Selecting one would automatically eliminate accepting the other. D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 33. Two projects are considered to be independent if A) selecting one would have no bearing on accepting the other. B) their cash flows are unrelated. C) Both a and b D) None of the above Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 34. Two projects are considered to be mutually exclusive if A) the projects perform the same function. B) selecting one would automatically eliminate accepting the other. C) Both a and b D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 35. Two projects are considered to be contingent projects if A) selecting one would automatically eliminate accepting the other. B) the acceptance of one project is dependent on the acceptance of the other. C) rejection of one project does not eliminate the selection of the other. D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 36. Contingent projects would imply that A) the acceptance of one project is dependent on the acceptance of the other. B) the projects can be either mandatory or optional. C) Both a and b. D) None of the above Ans: C

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Reference 10-1: Use the following to answer questions 37-38: A construction firm is evaluating two value-adding projects. The first project deals with building access roads to a new terminal at the local airport. The second project is to build a parking garage on a piece of land that the firm owns adjacent to the airport.

Reference: Ref 10-1 Format: Multiple Choice Learning Objective: LO 1 Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective Level of Difficulty: Medium 37. The firm's decision will be to A) accept both projects because they are independent projects. B) accept both projects because they are contingent projects. C) pick the one that adds the most value because they are mutually exclusive projects. D) pick neither project. Ans: A

Reference: Ref 10-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 38. If both projects are positive-NPV projects, then the firm should A) accept both projects because they are independent projects. B) select the higher NPV project because they are mutually exclusive. C) accept both projects because they are contingent projects. D) Not enough information is given to make a decision. Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 39. The cost of capital is A) the minimum return that a capital project must earn to be accepted. B) the maximum return a project can earn. C) the return that a previous project for the firm had earned. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 40. Capital rationing implies that A) a firm has constraint to fund all of the available projects. B) funding needs is equal to funding resources. C) the available capital will be allocated equally to all available projects. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 41. Capital rationing implies that A) funding resources exceed funding needs. B) funding needs exceed funding resources. C) funding needs equal funding resources. D) None of the above Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 42. Which one of the following statements is NOT true? A) Accepting a positive-NPV project increases shareholder wealth. B) Accepting a negative-NPV project has no impact on shareholder wealth. C) Accepting a negative-NPV project decreases shareholder wealth. D) Managers are indifferent about accepting or rejecting a zero NPV project. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 43. Which one of the following statements is NOT true? A) Accepting a positive-NPV project increases shareholder wealth. B) Accepting a negative-NPV project decreases shareholder wealth. C) Accepting a zero NPV project has a negative impact on shareholder wealth. D) Managers are indifferent about accepting or rejecting a zero NPV project. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 44. In computing the NPV of a capital budgeting project, one should NOT A) estimate the cost of the project. B) discount the future cash flows over the project's expected life. C) ignore the salvage value. D) make a decision based on the project's NPV. Ans: C

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 45. The net present value A) uses the discounted cash flow valuation technique. B) will provide a direct measure of how much a firm’s value will change because of the capital project. C) is consistent with shareholder wealth maximization goal. D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 46. To accept a capital project when using NPV, A) the project NPV should be less than zero. B) the project NPV should be greater than zero. C) Both a and b D) None of the above Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 47. The Cyclone Golf Resorts is redoing its golf course at a cost of $2,744,320. It expects to generate cash flows of $1,223,445, $2,007,812, and $3,147,890 over the next three years. If the appropriate discount rate for the firm is 13 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $7,581,072 B) $2,092,432 C) $4,836,752 D) $3,112,459 Ans: B Feedback: Initial investment = $2,744,320 Length of project = n = 3 years Required rate of return = k = 13% Net present value = NPV n

NCFt $1, 223, 445 $2, 007,812 $3,147,890 = −$2, 744,320 + + + t (1.13)1 (1.13) 2 (1.13)3 t = 0 (1 + k ) = −$2, 744,320 + $1, 082, 695 + $1,572, 411 + $2,181, 646 = $2, 092, 432

NPV = 

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 48. Cortez Art Gallery is adding to its existing buildings at a cost of $2 million. The gallery expects to bring in additional cash flows of $520,000, $700,000, and $1,000,000 over the next three years. Given a required rate of return of 10 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $1,802,554 B) $197,446 C) –$1,802,554 D) –$197,446 Ans: D Feedback: Initial investment = $2,000,000 Length of project = n = 3 years Required rate of return = k = 10% Net present value = NPV n

NCFt $520, 000 $700, 000 $1, 000, 000 = −$2000, 000 + + + t (1.10)1 (1.10) 2 (1.10)3 t = 0 (1 + k ) = −$2, 000, 000 + $472, 727 + $578,512 + $751,315 = −$197, 446

NPV = 

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 49. Johnson Entertainment Systems is setting up to manufacture a new line of video game consoles. The cost of the manufacturing equipment is $1,750,000. Expected cash flows over the next four years are $725,000, $850,000, $1,200,000, and $1,500,000. Given the company's required rate of return of 15 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $1,169,806 B) $2,919,806 C) $4,669,806 D) $3,122, 607 Ans: A Feedback: Initial investment = 1,750,000 Length of project = n = 4 years Required rate of return = k = 15% Net present value = NPV n

NCFt $725, 000 $850, 000 $1, 200, 000 $1,500, 000 = −$1, 750, 000 + + + + t (1.15)1 (1.15) 2 (1.15)3 (1.15) 4 t = 0 (1 + k ) = −$1, 750, 000 + $630, 435 + $642, 722 + $789, 019 + $857, 630 = $1,169, 806

NPV = 

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 50. Gao Enterprises plans to build a new plant at a cost of $3,250,000. The plant is expected to generate annual cash flows of $1,225,000 for the next five years. If the firm's required rate of return is 18 percent, what is the NPV of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $2,875,000 B) $3,830,785 C) $580,785 D) $2, 225,875 Ans: C Feedback: Initial investment = $3,250,000 Annual cash flows = $1,225,000 Length of project = n = 5 years Required rate of return = k = 18% Net present value = NPV

1   1−  FCFt (1.18)5  NPV =  = −$3, 250, 000 + $1, 225, 000    t t = 0 (1 + k )  0.18    = −$3, 250, 000 + $3,830, 785 = $580, 785 n

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 51. Jenkins Corporation is investing in a new piece of equipment at a cost of $6 million. The project is expected to generate annual cash flows of $1,850,000 over the next six years. The firm's cost of capital is 20 percent. What is the project's NPV? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $722,604 B) $351,097 C) $152,194 D) $261,008 Ans: C Feedback: Initial investment = $6,000,000

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Annual cash flows = $1,850,000 Length of project = n = 6 years Required rate of return = k = 20% Net present value = NPV

1   1−  FCFt (1.20)6  NPV =  = − $6, 000, 000 + $1,850, 000    t t = 0 (1 + k )  0.20    = −$6, 000, 000 + $6,152,194 = $152,194 n

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 52. Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the net present value of this project? (Do not round intermediate computations. Round final answer to nearest million dollars.) A) $10 million B) $12 million C) $14 million D) $16 million Ans: C Feedback: Initial investment = $30,000,000 Length of investment = n = 3 years Required rate of return = k = 20% Net present value = NPV n

NCFt $13, 000, 000 $23, 000, 000 $29, 000, 000 = −$30, 000, 000 + + + t (1.20)1 (1.20) 2 (1.20)3 t = 0 (1 + k ) = −$30, 000, 000 + $10,833,333 + $15,972, 222 + $16, 782, 407 = $13, 587, 963

NPV = 

= 14 million (rounded)

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 53. Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the net present value of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $645,366 B) $1,213,909 C) $905,888 D) $777,713 Ans: D Feedback: Initial investment = $8,500,000 Length of investment = n = 4 years Required rate of return = k = 16% Net present value = –$8,500,000 + [$2,000,000 / 1.16] + [3,000,000 / (1.16)2] + [$4,000,000 / (1.16)3] + [$5,000,000 / (1.16)4] = $777,713

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 54. Strange Manufacturing Company is purchasing a production facility at a cost of $21 million. The firm expects the project to generate annual cash flows of $7 million over the next five years. Its cost of capital is 18 percent. What is the net present value of this project? (Do not round intermediate computations. Round final answer to nearest dollar.) A) $890,197 B) $1,213,909 C) $905,888 D) $777,713 Ans: A Feedback: Initial investment = $21,000,000 Length of investment = n = 5 years Annual cash flows = $7,000,000 Required rate of return = k = 18% Net present value = NPV

1   1−  FCFt (1.18)5  NPV =  = − $21, 000, 000 + $7, 000, 000    t t = 0 (1 + k )  0.18    = −$21, 000, 000 + $21,890,197 = $890,197 n

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 55. Which of the following is true about the Net Present Value method? A) The NPV does not utilize time value of money concepts. B) The NPV assumes that all cash flows are reinvested at the firm’s discount rate. C) The NPV allows projects to be ranked by rate of return. D) The NPV is a rate of return that is acceptable to the firm. Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comrpehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 56. Which of the following statements about the payback method is true? A) The payback method is consistent with the goal of shareholder wealth maximization B) The payback method represents the number of years it takes a project to recover its initial investment plus a required rate of return. C) There is no economic rational that links the payback method to shareholder wealth maximization. D) None of the above statements are true. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 57. Which one of the following statements about the discounted payback method is NOT true? A) The discounted payback method represents the number of years it takes a project to recover its initial investment. B) The discounted payback method calls for a project to be accepted if the payback period is greater than a target period. C) The discount payback method is a risk indicator. D) The expected cash flows from a project are discounted at the cost of capital. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 58. Which of the following is an advantage of the payback method? A) The technique is simple for managers to compute and interpret. B) It is a good measure of liquidity risk. C) Both a and b D) None of the above Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 59. Which of the following is a disadvantage of the payback method? A) It ignores the time value of money. B) It is inconsistent with the goal of maximizing shareholder wealth. C) It ignores cash flows beyond the payback period. D) All of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 60. Binder Corp. has invested in new machinery at a cost of $1,450,000. This investment is expected to produce cash flows of $640,000, $715,250, $823,330, and $907,125 over the next four years. What is the payback period for this project? (Round your answer to two decimal places.) A) 2.12 years B) 1.88 years C) 4.00 years D) 3.00 years. Ans: A Feedback: Binder Corp. Year CF Cumulative CF 0 $(1,450,000) $(1,450,000) 1 640,000 (810,000) 2 715,250 (94,750) 3 823,330 728,580 4 907,125 1,635,705 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 2 + ($94,750 / $823,330) = 2.12 years

10-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 61. Elmer Sporting Goods is getting ready to produce a new line of golf clubs by investing $1.85 million. The investment will result in additional cash flows of $525,000, $812,500, and 1,200,000 over the next three years. What is the payback period for this project? (Round your answer to two decimal places.) A) 3.55 years B) 2.43 years C) 1.57 years D) More than 3 years Ans: B Feedback: Elmer Sporting Goods Year CF Cumulative CF 0 $(1,850,000) $(1,850,000) 1 525,000 (1,325,000) 2 812,500 (512,500) 3 1,200,000 687,500 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 2 + ($512,500 / $1,200,000) = 2.43 years

10-26

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 62. Creighton, Inc. has invested $2,165,800 on equipment. The firm uses payback period criteria of not accepting any project that takes more than four years to recover costs. The company anticipates cash flows of $424,386, $512,178, $561,755, $764,997, $816,500, and $825,375 over the next six years. What is the payback period, and does this investment meet the firm's payback criteria? (Round your answer to two decimal places.) A) 4.13 years; no B) 4.13 years; yes C) 3.87 years; yes D) 3.87 years; no Ans: C Feedback: Creighton Inc. Year CF Cumulative CF 0 $(2,165,800) $(2,165,800) 1 424,386 (1,741,414) 2 512,178 (1,229,236) 3 561,755 (667,481) 4 764,997 97,516 5 816,500 914,016 6 825,375 1,739,391 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 3 + ($667,481 / $764,997) = 3.87 years Since the payback period of 3.87 years is less than the decision criteria of 4 years, this project should be accepted.

10-27

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 63. Kathleen Dancewear Co. has bought some new machinery at a cost of $1,250,000. The impact of the new machinery will be felt in the additional annual cash flows of $375,000 over the next five years. What is the payback period for this project? If its acceptance period is three years, will this project be accepted? (Round your answer to two decimal places.) A) 2.67 years; yes B) 2.67 years; no C) 3.33 years; yes D) 3.33 years; no Ans: D Feedback: Kathleen Dancewear Inc. Year CF Cumulative CF 0 $(1,250,000) $(1,250,000) 1 375,000 (875,000) 2 375,000 (500,000) 3 375,000 (125,000) 4 375,000 250,000 5 375,000 625,000 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 3 + ($125,000 / $375,000) = 3.33 years Since the payback period of 3.33 years exceeds the decision criteria of 3 years, this project should be rejected.

10-28

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 64. Carmen Electronics bought new machinery for $5 million. This is expected to result in additional cash flows of $1.2 million over the next seven years. What is the payback period for this project? If its acceptance period is five years, will this project be accepted? (Round your answer to two decimal places.) A) 4.17 years; yes B) 4.17 years; no C) 3.83 years; yes D) 3.83 years; no Ans: A Feedback: Carmen Electronics Year CF Cumulative CF 0 $(5,000,000) $(5,000,000) 1 1,200,000 (3,800,000) 2 1,200,000 (2,600,000) 3 1,200,000 (1,400,000) 4 1,200,000 (200,000) 5 1,200,000 1,000,000 6 1,200,000 2,200,000 7 1,200,000 3,400,000 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 4 + ($200,000 / $1,200,000) = 4.17 years Since the payback period of 4.17 years is less than the decision criteria of 5 years, this project should be accepted.

10-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 65. Roswell Energy Company is installing new equipment at a cost of $10 million. Expected cash flows from this project over the next five years will be $1,045,000, $2,550,000, $4,125,000, $6,326,750, and $7,000,000. The company's discount rate for such projects is 14 percent. What is the project's discounted payback period? (Do not round intermediate computations. Round your answer to one decimal place.) A) 4.2 years B) 4.4 years C) 4.8 years D) 5.0 years Ans: A Feedback: Roswell Energy i = 14% Cumulative PVCF Year CF PVCF 0 $(10,000,000) $(10,000,000) $(10,000,000) 1 1,045,000 916,667 (9,083,333) 2 2,550,000 1,962,142 (7,121,191) 3 4,125,000 2,784,258 (4,336,934) 4 6,326,750 3,745,944 (590,990) 5 7,000,000 3,635,581 3,044,591 Discounted PB = Years before cost recovery + (Remaining cost to recover/ Present value of Cash flow during the year) = 4 + ($590,990/ $3,635,581) = 4.16 years or 4.2 years

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 66. Carmen Electronics bought new machinery for $5 million. This is expected to result in additional cash flows of $1.2 million over the next seven years. The firm's cost of capital is 12 percent. What is the discounted payback period for this project? If the firm's acceptance period is five years, will this project be accepted? (Do not round intermediate computations. Round your answer to one decimal place.) A) 5.4 years; no B) 6.1 years; no C) 6.1 years; yes D) 4.2 years; yes Ans: B Feedback: Carmen Electronics i = 12% Cumulative PVCF Year CF PVCF 0 $(5,000,000) $(5,000,000) $(5,000,000) 1 1,200,000 1,071,429 (3,928,571) 2 1,200,000 956,633 (2,971,939) 3 4

1,200,000 1,200,000

854,136 762,622

(2,117,802) (1,355,181)

1,200,000

680,912

(674,269)

6 1,200,000 607,957 (66,311) 7 1,200,000 542,819 476,508 Discounted PB = Years before cost recovery + (Remaining cost to recover/ Present value of Cash flow during the year) = 6 + ($66,311 / $542,819) = 6.12 years Since the payback period of 6.12 years exceeds the decision criteria of 5 years, this project should be rejected.

10-31

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 67. Kathleen Dancewear Co. has bought some new machinery at a cost of $1,250,000. The impact of the new machinery will be felt in the additional annual cash flows of $375,000 over the next five years. The firm's cost of capital is 10 percent. What is the discounted payback period for this project? If its acceptance period is three years, will this project be accepted? (Do not round intermediate computations. Round your answer to one decimal place.) A) 2.7 years; yes B) 4.7 years; no C) 2.3 years; yes D) 4.3 years; no Ans: D Feedback: Kathleen Dancewear Inc. i = 10% Cumulative PVCF Year CF PVCF 0 $(1,250,000) $(1,250,000) $(1,250,000) 1 375,000 340,909 (909,091) 2 375,000 309,917 (599,174) 3 375,000 281,743 (317,431) 4 375,000 256,130 (61,300) 5 375,000 232,845 171,545 Discounted PB = Years before cost recovery + (Remaining cost to recover/ Present value of Cash flow during the year) = 4 + ($61,300 / $232,845) = 4.26 years Since the payback period of 4.3 years exceeds the decision criteria of 3 years, this project should be rejected.

10-32

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 68. Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the payback period for this project? (Round your answer to one decimal place.) A) 1.7 years B) 2.2 years C) 1.2 years D) 2.7 years Ans: A Feedback: Initial investment = $30,000,000 Length of investment = n = 3 years Turnbull Corp. i = 20.00% Year CF Cumulative CF 0 $(30,000,000) $(30,000,000) 1 13,000,000 (17,000,000) 2 23,000,000 6,000,000 3 29,000,000 35,000,000 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 1 + ($17,000,000 / $23,000,000) = 1.74 years or 1.7 years

10-33

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 69. Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the payback period for this project? (Round your answer to one decimal place.) A) 2.7 years B) 2.9 years C) 3.1 years D) 3.4 years Ans: B Feedback: Initial investment = $8,500,000 Length of investment = n = 4 years Jamaica Inc. i = 16.00% Year CF Cumulative CF 0 $(8,500,000) $(8,500,000) 1 2,000,000 (6,500,000) 2 3,000,000 (3,500,000) 3 4,000,000 500,000 4 5,000,000 5,500,000 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year) = 2 + ($3,500,000/ $4,000,000) = 2.88 years or 2.9 years

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 70. Strange Manufacturing Company is purchasing a production facility at a cost of $21 million. The firm expects the project to generate annual cash flows of $7 million over the next five years. Its cost of capital is 18 percent. What is the payback period for this project? A) 2.8 years B) 3.0 years C) 3.2 years D) 3.4 years Ans: B Feedback: Initial investment = $21,000,000

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Fundamentals of Corporate Finance 3e

Test Bank

Length of investment = n = 5 years Annual cash flows = $7,000,000 Strange Manufacturing i = 18.00% Year CF Cumulative CF 0 $(21,000,000) $(21,000,000) 1 7,000,000 (14,000,000) 2 7,000,000 (7,000,000) 3 7,000,000 -4 7,000,000 7,000,000 5 7,000,000 14,000,000 PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year = 3 + ($0 / $7,000,000) = 3.0 years

10-35

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 71. You have been asked to analyze an investment project. The project’s cost is $180,000. Cash inflows are projected to be: year 1 = $55,000, year 2 = $65,000; year 3 = $75,000; year 4 = $85,500; year 5 = $95,000. What is the investment project’s payback? (Round off to the nearest 0.1 years) A) 4.1 years B) 1.6 years C) 3.5 years D) 2.8 years Ans: D Feedback: Payback Method Estimated Cumulative Year Cash Flows Cash Flows 0 ($180,000) (180,000) 1 55,000 (125,000) 2 65,000 (60,000) 3 75,000 15,000 4 85,500 100, 500 5 95,000 195, 500 = 2.80 Years

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 72. LaGrange Corp. has forecasted that over the next four years the average annual after-tax income will be $45,731. The average book value of the manufacturing equipment that is used is $167,095. What is the accounting rate of return? (Round your answer to one decimal place.) A) 33.3% B) 27.4% C) 29.8% D) 22.3% Ans: B Feedback: Annual after-tax income = $45,731 Average after-tax income = ($45,731+$45,731 + $45,731+$45,731) / 4 = $45,731 Average book value of equipment = $167,095

Average after-tax income Average book value $45, 731 = = 27.4% $167, 095

Accounting rate of return =

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 73. Stump Storage Co. is expecting to generate after-tax income of $155,708, $159,312, and $161,112 for each of the next three years. The equipment used will have an average book value of $251,575 over that period. What is the ARR? (Do not round intermediate computations. Round final answer to one decimal place.) A) 65.7% B) 69.4% C) 63.1% D) 66.8% Ans: C Feedback: Average after-tax income = ($155,708+$159,312 +$161,112) / 3 = $158,711 Average book value of equipment = $251,575

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Fundamentals of Corporate Finance 3e

Test Bank

Average after-tax income Average book value $158, 711 = = 63.1% $251,575

Accounting rate of return =

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 74. Which of the following statements about IRR is NOT true? A) The IRR is the discount rate that makes the NPV greater than zero. B) The IRR is a discounted cash flow method. C) The IRR is an expected rate of return. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 75. The internal rate of return is A) the discount rate that makes the NPV greater than zero. B) the discount rate that makes the NPV equal to zero. C) the discount rate that makes the NPV less than zero. D) Both a and c are correct. Ans: B

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 76. When evaluating capital projects, the decisions using the NPV method and the IRR method will agree if A) the projects are independent. B) the cash flow pattern is conventional. C) the projects are mutually exclusive. D) Both a and b are correct. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 77. In evaluating capital projects, the decisions using the NPV method and the IRR method may disagree if A) the projects are independent. B) the cash flows pattern is unconventional. C) the projects are mutually exclusive. D) Both b and c are correct. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 78. Which of the following cash flow patterns is NOT an unconventional cash flow pattern? A) A positive initial cash flow is followed by negative future cash flows. B) A cash flow pattern in which there are alternate inflows and outflows. C) A negative initial cash flow is followed by positive future cash flows. D) A cash flow stream looks similar to a conventional cash flow stream except for a final negative cash flow. Ans: C

10-39

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 79. Quick Sale Real Estate Company is planning to invest in a new development. The cost of the project will be $23 million and is expected to generate cash flows of $14,000,000, $11,750,000, and $6,350,000 over the next three years. The company's cost of capital is 20 percent. What is the internal rate of return on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 22% B) 20% C) 24% D) 28% Ans: A Feedback: Initial investment = $23,000,000 Length of project = n = 3 years Required rate of return = k = 20% To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR = 21.6%. 𝑛

𝑁𝑃𝑉 = 0 = ∑ 𝑡=0

𝐹𝐶𝐹𝑡 (1 + 𝐼𝑅𝑅)𝑡

0 = -$23,000,000 +

$14,000,000 (1.216)2

$11,750,000 (1.216)2

$6,350,000

+ (1.216)3

= $23,000 + $11,513,158 + $7,946,405 + $3,531,612 = -$8,825 ≅ 0 The IRR of the project is 21.6 percent. Using a financial calculator, we find that the IRR is 21.572 percent.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 80. Modern Federal Bank is setting up a brand new branch. The cost of the project will be $1.2 million. The branch will create additional cash flows of $235,000, $412,300, $665,000 and $875,000 over the next four years. The firm's cost of capital is 12 percent. What is the internal rate of return on this branch expansion? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 20% B) 23% C) 25% D) 27% Ans: B Feedback: Initial investment = $1,200,000 Length of project = n = 4 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =23.1%. 𝑛

𝑁𝑃𝑉 = 0 = ∑ 𝑡=0

𝐹𝐶𝐹𝑡 (1 + 𝐼𝑅𝑅)𝑡

$235,000

$412,300

$665,000

$875,000

0 = -$1,200,000 + (1.231)1 + (1.231)2 + (1.231)3 + (1.231)4

= $1,200,000 + $190,902 + $272,080 + $356,490 + $381,045 = $517 ≅ 0 The IRR of the project is 23.1 percent. Using a financial calculator, we find that the IRR is 23.119 percent.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 81. Signet Pipeline Co. is looking to install new equipment that will cost $2,750,000. The cash flows expected from the project are $612,335, $891,005, $1,132,000, and $1,412,500 for the next four years. What is Signet's internal rate of return? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 11% B) 13% C) 15% D) 17% Ans: C Feedback: Initial investment = $2,750,000 Length of project = n = 4 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =15.1%. 𝑛

𝑁𝑃𝑉 = 0 = ∑ 𝑡=0

𝐹𝐶𝐹𝑡 (1 + 𝐼𝑅𝑅)𝑡 $612,335

$891,005

$1,132,000

$1,412,500

0 = -$2,750,000 + (1.151)1 + (1.151)2 + (1.151)3 + (1.151)4

= -$2,750,000+ $532,003 + $672,558 + $742,370 + $804,799 = $1,729 ≅ 0 The IRR of the project is 15.1 percent. Using a financial calculator, we find that the IRR is 15.127 percent.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 82. Casa Del Sol Property Development Company is refurbishing a 200-unit condominium complex at a cost of $1,875,000. It expects that this will lead to expected annual cash flows of $415,350 for the next seven years. What internal rate of return can the firm earn from this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 10% B) 12% C) 14% D) 16% Ans: B Feedback: Initial investment = $1,875,000 Annual cash flows = $415,350 Length of investment = n = 7 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =12.3%.

1   1− 7   FCFt (1.123) NPV = 0 =  = −$1,875, 000 + $415,350    t t = 0 (1 + IRR )  0.123    0 = −$1,875, 000 + $1,877, 660 = $2, 660  0 n

The IRR of the project is 12.3 percent. Using a financial calculator, we find that the IRR is 12.345 percent.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 83. Lowell Communications, Inc., has been installing a fiber-optic network at a cost of $18 million. The firm expects annual cash flows of $3.7 million over the next 10 years. What is this project's internal rate of return? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 10% B) 12% C) 14% D) 16% Ans: D Feedback: Initial investment = $18,000,000 Annual cash flows = $3,700,000 Length of investment = n = 10 years To determine the IRR, the trial-and-error approach can be used. Set NPV = 0. Try IRR =15.8%.

1   1− 10   FCFt (1.158) NPV = 0 =  = −$18, 000, 000 + $3, 700, 000    t t = 0 (1 + IRR )  0.158    0 = −$18, 000, 000 + $18, 016,910 = $16, 910  0 n

The IRR of the project is 15.8 percent. Using a financial calculator, we find that the IRR is 15.825 percent.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 84. Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the internal rate of return that Turnbull can earn on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 41% B) 42% C) 43% D) 44% Ans: D Feedback: Initial investment = $30,000,000 Length of investment = n = 3 years Since NPV > 0, try IRR > 20%. Try IRR = 43.6%.

𝑁𝑃𝑉 = 0 = ∑𝑛𝑡=0 (1

𝑁𝐶𝐹𝑡 +𝐼𝑅𝑅)𝑡

= -$30,000,000 +

$13,000,000 (1.436)1

$23,000,000 (1436)2

$29,000,000 (1.436)3

= -$30,000,000 + $9,052,925 + $11,153,700 + $9,793,427 = $51 ≅ 0

10-45

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 85. Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the MIRR on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 36% B) 37% C) 38% D) 39% Ans: A Feedback: PV of costs = $30,000,000 Length of project = n = 3 years Cost of capital = k = 20%

TV = CF1 (1 + k ) n −1 + CF2 (1 + k ) n −2 +

+ CFn (1 + k ) n − n

= $13, 000, 000(1.20)2 + $23, 000, 000(1.20)1 + $29, 000, 000(1.20)0 = $18, 720, 000 + $27, 600, 000 + $29, 000, 000 = $75,320, 000 TV PVCosts = (1 + MIRR)t $75,320, 000 $30, 000, 000 = (1 + MIRR)3 $75,320, 000 (1 + MIRR)3 = = 2.5107 $30, 000, 000 (1 + MIRR) = (2.5107) 3 = 1.3591 MIRR = 0.3591 = 35.9% 1

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 86. Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the internal rate of return that Jamaica can earn on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 18% B) 19% C) 20% D) 21% Ans: C Feedback: Initial investment = $8,500,000 Length of investment = n = 4 years Since NPV > 0, try IRR > 16%. Try IRR = 19.9%. Net present value = –$8,500,000 + [$2,000,000 / 1.199] + [3,000,000 / (1.199)2] + [$4,000,000 / (1.199)3] + [$5,000,000 / (1.199)4] = -5,202 The IRR of the project is 19.9 percent. Using a financial calculator, we find that the IRR is 19.872 percent.

10-47

Fundamentals of Corporate Finance 3e

Test Bank

TV = CF1 (1 + k ) n −1 + CF2 (1 + k ) n −2 +

+ CFn (1 + k ) n −n

= $2, 000, 000(1.16)3 + $3, 000, 000(1.16)2 + $4, 000, 000(1.16)1 + $5, 000, 000(1.16)0 = $3,121, 792 + $4, 036,800 + $4, 640, 000 + $5, 000, 000 = $16, 798,592 TV PVCosts = (1 + MIRR)t $16, 798,592 $8,500, 000 = (1 + MIRR) 4 $16, 798,592 (1 + MIRR) 4 = = 1.9763 $8,500, 000 (1 + MIRR) = (1.9763) 4 = 1.1857 MIRR = 0.1857 = 18.6% 1

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 88. Strange Manufacturing Company is purchasing a production facility at a cost of $21 million. The firm expects the project to generate annual cash flows of $7 million over the next five years. Its cost of capital is 18 percent. What is the internal rate of return on this project? (Do not round intermediate computations. Round final answer to the nearest percent.) A) 17% B) 18% C) 19% D) 20% Ans: D Feedback: Initial investment = $8,500,000 Length of investment = n = 4 years Since NPV > 0, try IRR > 18%. Try IRR = 19.9%.

1   1−  FCFt (1.199)5  NPV =  = −$21, 000, 000 + $7, 000, 000    t t = 0 (1 + k )  0.199    = −$21, 000, 000 + $20,980, 433 = −$19, 567  0 n

The IRR of the project is 19.9 percent. Using a financial calculator, we find that the IRR is 19.858 percent.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 89. What difficulties are associated with valuing real assets compared to financial assets? Ans: The valuation of real assets is less straightforward than the valuation of financial assets for several reasons: • First, in many cases, cash flows for financial assets are well documented in a legal contract. If they are not, we are at least able to make some reasonable assumptions about what they are. For real assets, no such information exists. Specialists within the firm, usually from the finance, marketing, and production groups, prepare estimates of future cash flows for the capital project. • Second, many financial securities are traded in public markets, and these markets are reasonably efficient. Thus, market data on rates of return are accessible. For real assets, no such markets exist. As a result, we must look at investors' opportunity cost, the rate of return they give up when they invest in real assets rather than financial assets. We must estimate required rates of return on real assets from market data on financial assets, which can be difficult to do.

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 90. What are the advantages of the net present value technique? Ans: 1. Uses the discounted cash flow valuation technique to adjust for the time value of money. 2. Provides a direct measure of how much a capital project will increase the value of the firm. 3. Consistent with the goal of maximizing stockholder value.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 5 Level of difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 91. Explain under what circumstances the NPV and IRR could provide different decisions. Ans: The IRR and NPV methods can produce different accept/reject decisions: • If a project either has unconventional cash flows or the projects are mutually exclusive. Unconventional cash flows could follow several different patterns. It could be a positive initial cash flow followed by negative future cash flows, or both positive and negative cash flows, or, a cash flow stream that looks similar to a conventional cash flow stream except for a final negative cash flow. • When you are comparing two mutually exclusive projects, the NPVs of the two projects will equal each other at a certain discount rate. This point at which the NPVs intersect is called the crossover point. Depending on whether the required rate of return is above or below this cross-over point, the ranking of the projects will be different. While it is easy to identify the superior project based on the NPV, one cannot do so based on the IRR. Thus, ranking conflicts can arise. • A second situation involves comparison of projects with different costs. While IRR gives you a return based on the dollar invested, it does not recognize the difference in the size of the investments. NPV does!

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Difficult Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 92. Crossover Point/Rate: Packard Electronics Corp. is evaluating the two mutually exclusive projects shown below. Boundless Corp. Project A Project B Period Cash Flows Cash Flows 0 $ (100,000) $ (150,000) 1 50,000 15,000 2 40,000 30,000 3 30,000 50,000 4 20,000 70,000 5 10,000 80,000 What is the “crossover rate” of the two projects? (Round off to the nearest (0.01%)) A) 10.82% B) 8.24% C) 13.76% D) 16.38% Ans: A Feedback: Boundless Corp. Period 0

Project A

Project B

Cash Cash Flows Flows $(100,000) $(150,000)

Project A WACC NPV

Project B NPV

Diff in CF's A vs. B

0.0%

50,000

15,000

5.0%

40,000

30,000

10.0%

30,000

50,000

12.5%

20,000

70,000

15.0%

10,000

80,000

17.5%

50,000

95,000

50,000

34,105

54,960

35,000

20,921

23,480

10,000

15,155

10,249

(20,000)

9,856

(1,600)

(50,000)

4,976 IRR

(12,240) IRR

(70,000) IRR = 10.82 %

20.27% 14.65%

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Fundamentals of Corporate Finance 3e

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Chapter 11: Cash Flows and Capital Budgeting

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 1. The term incremental in the context of incremental after-tax free cash flows refers to the fact that the firm's total after-tax free cash flows will change if the new project is adopted. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 2. Conceptually, free cash flows are what is left over for distribution to creditors and stockholders after the firm has made the necessary investments in working capital and long-term assets. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 3. Incremental cash flow from operations is the cash flow from a project that is expected to be generated after all operating expenses and taxes have been paid. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 4. The purchase of a factory building for a prospective project is an example of an incremental addition to working capital. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 5. If a firm expects to increase its investment in inventory due to a prospective project, then this is an example of an incremental capital expenditure. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 6. The stand-alone principle says that we can treat a project as if it were a stand-alone firm that has its own revenue, expenses, and investment requirements. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 7. If you start with incremental net operating profits after tax (NOPAT) and add depreciation and amortization to it, then you will obtain incremental cash flow from operations. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 8. Free cash flow equals cash flow from operations minus required investments. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 9. Increases in working capital are considered cash flows associated with investments. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 10. Accounting earnings are a reliable measure of the costs and benefits of a project. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 11. If taken without accompanying changes in cash flow, changes in a company's accounting earnings do not impact the overall value of the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 12. Allocated costs such as corporate overhead should be included in cash flow calculations. A) True B) False Ans: B

11-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 13. The impact of a project on another project's cash flows should be ignored. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 14. Opportunity costs should always be included in the cash flow calculations of a project. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 15. The research and development costs to date of a project should be considered when analyzing the cash flows of a prospective project. A) True B) False Ans: B

11-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 16. Since our perspective when evaluating a project is that of all of the investors in the firm, creditors as well as stockholders, then we should evaluate the pretax cash flows produced by a project. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 17. Since our perspective when evaluating a project is that of all the shareholders only, then we should evaluate the after-tax cash flows produced by a project. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 18. BioGeological Pharmaceuticals invested $100 million on a heart drug that does not prevent heart disease. BioGeological has since found that the drug does prevent diabetes. When considering whether to market the drug as a diabetic panacea, the firm should consider the $100 million spent while investigating the heart-related effects. A) True B) False Ans: B

11-6

Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 19. When analyzing a project, if the expected future cash flows are denominated in nominal dollars, then the discount rate should represent a nominal rate as well. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 20. Nominal interest rates incorporate the expected rate of inflation. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 21. If the current market price of corn is $100 per bushel and the nominal rate of interest is 10 percent, then the real price of corn next period should also be $100. A) True B) False Ans: A

11-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 22. A progressive tax system means that a taxpayer will pay a higher tax rate for a given dollar of earnings for every successive year. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 23. It is possible for a firm to have one depreciation schedule for tax purposes and another for financial reporting purposes. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 24. The MACRS depreciation tax schedule for three-year equipment provides a depreciation rate for a total of four years. A) True B) False Ans: A

11-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 25. Terminal-year free cash flows may differ from the cash flows provided in the typical year of a project for reasons such as the return/repayment of increases/reductions in additional working capital in the prior years. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 26. If the salvage value, at the time of an asset disposition, is less than the book value of the asset, then the firm will effectively receive a positive cash flow from taxes on the sale. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 27. The expected cash flows for a project are fixed amounts that have zero variability in the projected values. A) True B) False Ans: B

11-9

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 28. The unadjusted NPV of two projects with different useful lives can be compared to evaluate which project is the better of the two. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 29. You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately if the current NPV of the project is positive. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 30. You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your firm is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately under all circumstances. A) True B) False Ans: B

11-10

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 31. The cash flows used in capital budgeting calculations are based on: A) historical estimates. B) forecasts of future cash revenues, expenses, and investment outlays. C) forecasts of net income. D) forecasts of retained earnings available for financing projects. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 32. The NPV of a project is estimated by: A) discounting the expected cash flows of a project in the future. B) discounting only the certain cash flows of a project in the future. C) discounting the variance of the expected cash flows of a project in the future. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 33. The ___________ is intended to reconcile changes in the balance sheet cash accounts. A) capital budgeting cash flow calculation B) accounting statement of cash flows C) accounting statement of income D) None of the above. Ans: B

11-11

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 34. The term ___________ refers to the fact that these cash flows reflect the amount by which the firm's total after-tax free cash flows will change if the project is adopted. A) Periodic B) ending cash flows C) Incremental D) None of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 35. _________ refers to the cash flow that a project is expected to generate after all operating expenses and taxes have been paid. A) Incremental cash flow from operations B) Operating income C) EBITDA D) None of the above. Ans: A

11-12

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 36. In order to calculate free cash flow by starting with incremental cash flow from operations, we should A) subtract the incremental capital expenditures and add the incremental additions to working capital. B) add the incremental capital expenditures and the incremental additions to working capital. C) subtract the incremental capital expenditures and the incremental additions to working capital. D) None of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 37. The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as: A) the stand-alone principle. B) the dependent principle. C) the independent principle. D) None of the above. Ans: A

11-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 38. The firm's ____________ is used to calculate NOPAT because the profits from a project are assumed to be incremental to the firm. A) average tax rate B) marginal tax rate C) lowest marginal tax rate D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 39. Additions to tangible assets, intangible assets ,and current assets can be described as: A) cash flows associated with investments. B) operating cash flows. C) free cash flows. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 40. The impact of a project on a firm's overall value depends on A) a firm's accounting earnings. B) a firm's cash flow. C) a project's cash flow. D) None of the above. Ans: C

11-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 41. Which of the following should not be included in a project's cash flow calculations? A) cash expenses B) cash revenues C) allocated expenses D) None of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 42. Corporate overhead allocations should only be taken into account on project analysis if: A) the firm is currently covering all of its overhead allocations. B) the firm is currently unable to cover all of its overhead allocations. C) the overhead allocations involve cash expenditures. D) None of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 43. Brown Mack, Inc., currently has two large manufacturing divisions that share a single plant. Brown Mack owns the plant but has calculated that $6 million of overhead expenses should be allocated to the two equal-sized divisions. If Brown Mack starts a third manufacturing division, of equal size to the other two divisions, then what overhead cost should the new division take into account on its capital budgeting cash flow analysis? A) $0 B) $2 million C) $3 million D) $6 million Ans: A

11-15

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 44. A firm is considering taking a project that will produce $12 million of revenue per year. Cash expenses will be $5 million, and depreciation expenses will be $1 million per year. If the firm takes that project, then it will reduce the cash revenues of an existing project by $2 million. What is the free cash flow on the project, per year, if the firm is in the 40 percent marginal tax rate? A) $2.4 million B) $3.4 million C) $4.6 million D) $5.0 million Ans: B Feedback: Revenue $12,000,000 Cash exp (5,000,000) Deprec exp (1,000,000) Lost revenue (2,000,000) Pretax income $ 4,000,000 Less taxes 1,600,000 Net income $ 2,400,000 Add Deprec 1,000,000 Free Cash Flow/yr $ 3,400,000

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 45. Whenever a project has a negative impact on an existing project's cash flows, then that effect should: A) be ignored. B) be ignored if the project is evaluated using the correct cost of capital. C) be included as a negative revenue amount on the new project's cash flow analysis. D) be included if the impact is limited to noncash expenditures. Ans: C

11-16

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 46. If a firm has the option of leasing some factory space to another firm or utilizing it for another product line, then if the firm chose the product line how should it handle the lost lease payments on the factory space? A) Ignore it. B) Include it as an opportunity cost. C) Include half of it as additional revenue for the project. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 47. Which of the following is the best example of a sunk cost? A) Future payments on a leased building. B) Future research and development costs. C) Historical research and development costs. D) Historical noncash expenses. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 48. _____________ represent dollars stated in terms of constant purchasing power. A) Nominal dollars B) Real dollars C) Inflated dollars D) None of the above Ans: B

11-17

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 49. If inflation is anticipated to be 10 percent during the next year while a nominal rate of 20 percent will be earned on U.S. Treasury bills, then what is the accurate real rate of return on these securities?(Round final percentage answer to decimal places.) A) 20.05% B) 10.01% C) 9.09% D) None of the above. Ans: C Feedback: 1 + k = (1 + Pe) x (1 + r) 1 + 0.2 = (1 + 0.1) x (1 + r) 1.0909 = 1 + r 0.0909 = r

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 50. If the real return on U.S. Treasury bills is 14 percent while the rate of expected inflation is anticipated to be 8 percent, then what should nominal rate of return be? (Round final percentage answer to decimal places.) A) 14.05% B) 33.05% C) 23.12% D) None of the above. Ans: C Feedback: 1 + k = (1 + Pe) x (1 + r) 1 + k = (1 + 0.08) x (1 + 0.14) 1 + k = 1.2312 k = 0.2312

11-18

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 51. If you are discounting a project's cash flows using the nominal cost of capital, then that means that you have taken the following into account: A) the real rate of return. B) the expected rate of inflation. C) Both of the above. D) None of the above. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 52. A tax system in which taxpayers pay a progressively larger share of their income in taxes as their income rises is called: A) a flat tax system. B) a progressive tax system. C) a digressive tax system. D) a political tax system. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 53. For a U.S. corporation with income above $20 million, A) the average tax rate is less than the marginal tax rate. B) the average tax rate is equal to the marginal tax rate. C) the average tax rate is greater than the marginal tax rate. D) None of the above. Ans: B

11-19

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 54. When compared to the straight-line depreciation method, MACRS has: A) a greater proportion of its depreciation early in the life of the asset. B) a lesser proportion of its depreciation early in the life of the asset. C) an equal proportion of its depreciation early in the life of the asset. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 55. In order for a project to generate a positive net working capital cash flow at the conclusion of a project, A) the project must have generated a cumulative negative cash flow during the life of the project. B) the project must have generated a cumulative positive cash flow during the life of the project. C) the project must have generated a cumulative negative cash flow at the conclusion of the project. D) the project could not have generated a positive cash flow at the opening of the project. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 56. If you are deciding whether to take one project or another, where the projects have different useful lives, then you could utilize: A) a repeated investment analysis to decide which project is better for the firm. B) an equivalent annual annuity analysis to decide which project is better for the firm. C) Either of the above. D) None of the above. Ans: C

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 57. Windy Burgers is trying to determine when to harvest a herd of cows that it currently owns. If it harvests the herd in year 1, the NPV of the project would increase over an immediate harvest by 25 percent. A year 2 harvest would create an NPV increase of 15 percent over that of year 1 and year 3 would create an NPV increase of 7 percent over that of year 2. If the cost of capital is 12 percent for Windy, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today. A) Harvest immediately. B) Harvest in year 1. C) Harvest in year 2. D) Harvest in year 3. Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 58. Stillwater Drinks is trying to determine when to harvest the water from the fountain of youth that it currently owns. If it harvests the water in year 1, the NPV of the project would increase over an immediate harvest by 18 percent. A year 2 harvest would create an NPV increase of 12 percent over that of year 1 and year 3 would create an NPV increase of 8 percent over that of year 2. If the cost of capital is 17 percent for Stillwater, then which harvest year would maximize the NPV for the firm? Assume that all NPVs are calculated from the perspective of today. A) Harvest immediately. B) Harvest in year 1. C) Harvest in year 2. D) Harvest in year 3. Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 59. The proper time to harvest an asset is when: A) the percentage NPV increase of harvesting a project at a future point in time is at the last date where the increase is greater than the cost of capital. B) the percentage NPV increase of harvesting a project at a future point in time is at the first date where the increase is less than the cost of capital. C) the percentage NPV increase of harvesting a project at a future point in time is at the first date where the increase is greater than the cost of capital. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 60. Norman, Inc., is considering two mutually exclusive projects. Project A is a six-year project with a NPV of $3,000 and Project B is a four-year project with an NPV of $2,278. Project A has an equivalent annual cash flow of $730 and Project B has an equivalent annual cash flow of $750. Which project should the firm select? A) Choose Project A because it has the higher NPV. B) Choose Project B because it has the lower NPV. C) Choose Project B because it has the higher equivalent annual cash flow. D) Choose Project A because it has the lower equivalent annual cash flow. Ans: C

Use the following to answer questions 61-64: Ref 11-1 Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent.

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Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 61. Free cash flow: What is Provo's cash flow from operations for 2008? A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Ans: C Feedback: Provo, Inc. Revenue $10,000,000 - Operating Ex 5,000,000 EBITDA $ 5,000,000 - D&A 1,000,000 EBIT $ 4,000,000 x (1 – t) 60% NOPAT $ 2,400,000 + D&A 1,000,000 CF Opns $ 3,400,000

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Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 62. Free cash flow: What is Provo's free cash flow for 2008? A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Ans: B Feedback: Provo, Inc. Revenue $10,000,000 - Operating Ex 5,000,000 EBITDA $ 5,000,000 - D&A 1,000,000 EBIT $ 4,000,000 x (1 – t) 60% NOPAT $ 2,400,000 + D&A 1,000,000 CF Opns $ 3,400,000 - Cap Exp $500,000 - Add WC 300,000 FCF $ 2,600,000

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Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 63. Free cash flow: What is Provo's NOPAT for 2008? A) $2,400,000 B) $2,600,000 C) $3,400,000 D) $4,000,000 Ans: A Feedback: Provo, Inc. Revenue $10,000,000 - Operating Ex 5,000,000 EBITDA $ 5,000,000 - D&A 1,000,000 EBIT $ 4,000,000 x (1 – t) 60% NOPAT $ 2,400,000

Reference: Ref 11-1 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium 64. Free cash flow: What is Provo's cash flows associated with investments for 2008? A) $300,000 B) $500,000 C) $800,000 D) None of the above. Ans: C

Use the following to answer questions 65-68: Ref 11-2 Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2008. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent.

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Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 65. Free cash flow: What is Champagne's cash flow from operations for 2008? A) $2,050,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Ans: C Feedback: Champagne, Inc. Revenue $12,000,000 - Operating Ex 8,000,000 EBITDA $ 4,000,000 - D&A 1,500,000 EBIT $ 2,500,000 x (1 – t) 70% NOPAT $ 1,750,000 + D&A 1,500,000 CF Opns $ 3,250,000

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Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 66. Free cash flow: What is Champagne's free cash flow for 2008? A) $2,050,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Ans: A Feedback: Champagne, Inc. Revenue $12,000,000 - Operating Ex 8,000,000 EBITDA $ 4,000,000 - D&A 1,500,000 EBIT $ 2,500,000 x (1 – t) 70% NOPAT $ 1,750,000 + D&A 1,500,000 CF Opns $ 3,250,000 - Cap Exp $700,000 - Add WC 500,000 FCF $ 2,050,000

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Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 67. Free cash flow: What is Champagne's NOPAT for 2008? A) $1,750,000 B) $2,500,000 C) $3,250,000 D) $4,000,000 Ans: A Feedback: Champagne, Inc. Revenue $12,000,000 - Operating Ex 8,000,000 EBITDA $ 4,000,000 - D&A 1,500,000 EBIT $ 2,500,000 x (1 – t) 70% NOPAT $ 1,750,000

Reference: Ref 11-2 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 68. Free cash flow: What are Champagne's cash flows associated with investments for 2008? A) $500,000 B) $700,000 C) $1,200,000 D) None of the above. Ans: C Feedback: Cash flows associated with investments equal the purchase of tangible and intangible assets as well as increases in working capital. Therefore, the cash flows associated with investments equal $700,000 + $500,000 = $1,200,000.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 69. Marginal and average tax rates: Use the tax rate taken from Exhibit 11.6 to calculate the total taxes paid for Lansing, Inc., this year. Lansing's pretax income was $275,000. Exhibit 11.6 U.S. Corporate Tax Rate Schedule in 2007 Taxable Income More But Not More Than Than Tax Owed $0 $50,000 15% of amount beyond $0 $50,000 $75,000 $7,500 + 25% of amount beyond $50,000 $75,000 $100,000 $13,750 + 34% of amount beyond $75,000 $100,000 $335,000 $22,250 + 39% of amount beyond $100,000 $335,000 $10,000,000 $113,900 + 34% of amount beyond $335,000 $10,000,000 $15,000,000 $3,400,000 + 35% of amount beyond $10,000,000 $15,000,000 $18,333,333 $5,150,000 + 38% of amount beyond $15,000,000 $18,333,333 ------35% on all income A) $22,500 B) $68,250 C) $90,500 D) $107,250 Ans: C Feedback: From the instruction in the table, we can see that the tax bill should be equal to $22,250 + 0.39 x ($275,000 - $100,000) = $22,250 + $68,250 = $90,500

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 70. Marginal and average tax rates: Use the tax rate taken from Exhibit 11.6 to calculate the average tax rate for Lansing, Inc., this year. Lansing's pretax income was $275,000. (Round final answer to nearest whole percent.) Exhibit 11.6 U.S. Corporate Tax Rate Schedule in 2007 Taxable Income More But Not More Than Than Tax Owed $0 $50,000 15% of amount beyond $0 $50,000 $75,000 $7,500 +25% of amount beyond $50,000 $75,000 $100,000 $13,750 +34% of amount beyond $75,000 $100,000 $335,000 $22,250 +39% of amount beyond $100,000 $335,000 $10,000,000 $113,900 +34% of amount beyond $335,000 $10,000,000 $15,000,000 $3,400,000 +35% of amount beyond $10,000,000 $15,000,000 $18,333,333 $5,150,000 +38% of amount beyond $15,000,000 $18,333,333 ------35% on all income A) 8.0% B) 25.0% C) 32.9% D) 39.0% Ans: C Feedback: From the instruction in the table, we can see that the tax bill should be equal to $22,250 + 0.39 x ($275,000 – $100,000) = $22,250 + $68,250 =$90,500. We see that the taxes due are $90,500 and with pretax income of $275,000, we then have an average tax rate of $90,500 / $275,000 = 32.90%.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 71. Computing the terminal-year FCF: Miles Cyprus Corp. purchased a truck that currently has a book value of $1,000. If the firm sells the truck for $5,000 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 30 percent marginal tax rate? A) $1,200 B) $3,800 C) $4,000 D) $5,000 Ans: B Feedback: The gain on the sale was $5,000 – $1,000 = $4,000 Taxes on the gain are: $4,000 x .3 = $1,200 Net cash flow from the sale is $5,000 – $1,200 = $3,800

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 72. Computing the terminal-year FCF: Babaloo Nightclubs, purchased a disco mirror that currently has a book value of $10,000. If Babaloo sells the disco mirror for $500 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 39 percent marginal tax rate? A) $500 B) $3,705 C) $4,205 D) $9,500 Ans: C Feedback: The loss on the sale was $10,000 – $500 = $9,500 The tax refund on the loss is: $9,500 x .39 = $3,705 Net cash flow from the sale is $500 + $3,705= $4,205

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 73. Expected cash flows: FireRock Wheel Corp is evaluating a project in which there is a 40 percent probability of revenues totaling $3 million and a 60 percent probability of revenues totaling $1 million per year. Its cash expenses will be $1.0 million while depreciation expense will be $200,000; then what is the expected free cash flow from taking the project if the marginal tax rate for the firm is 30 percent? A) $200,000 B) $420,000 C) $600,000 D) $620,000 Ans: D Feedback: Expected revenue = 0.4(3,000,000) + 0.6(1,000,000) = $1,800,000 Expected revenue $1,800,000 - Cash Expenses 1,000,000 - Deprec Expense 200,000 EBIT $ 600,000 - Tax 180,000 NI $ 420,000 + Deprec Expense 200,000 FCF $ 620,000

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 74. Projects with different lives: Your firm is deciding whether to purchase a durable delivery vehicle or a short-term vehicle. The durable vehicle costs $25,000 and should last five years. The short-term vehicle costs $10,000 and should last two years. If the cost of capital for the firm is 15 percent, then what is the equivalent annual cost for the best choice for the firm? (Round final answer to nearest whole dollar.) A) $5,000, either vehicle B) $5,000, short-term vehicle C) $6,151, short-term vehicle D) $7,458, long-term vehicle Ans: C Feedback:

 (1 + k )t  EAC = kNPV   t  (1 + k ) − 1 , therefore the  (1 + 0.15 )5  EACdurable = 0.15 ( $25, 000 )   = $7, 457.89 5  (1 + 0.15 ) − 1   (1 + 0.15 )2  EACshort −term = 0.15 ( $10, 000 )   = $6,151.16 2  (1 + 0.15 ) − 1  , since we are analyzing costs, we should choose the lowest cost per year, which is the short-term vehicle.

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 75. Projects with different lives: Your firm is deciding whether to purchase a high-quality printer for your office or one of lesser quality. The high-quality printer costs $40,000 and should last four years. The lesser quality printer costs $30,000 and should last three years. If the cost of capital for the firm is 13 percent, then what is the equivalent annual cost for the best choice for the firm? Round to the nearest dollar. A) $10,000, either printer B) $10,000, lesser quality printer C) $12,706, lesser quality printer D) $13,448, high-quality printer Ans: C Feedback:

 (1 + k )t  EAC = kNPV   t  (1 + k ) − 1 ; therefore the = 0.13 ($40,000)

= $13,447.77

 (1 + 0.13)3  EACshort −term = 0.13 ( $30, 000 )   = $12, 705.66 3  (1 + 0.13) − 1 , since we are analyzing costs, we should choose the lowest cost per year, which is the lesser quality printer.

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 76. When to harvest an asset: Cleveland Millicrum is considering when to harvest its moldy bread supply for antibiotics. It has calculated that the current NPV dollars for harvesting the bread are increasing according to the following schedule. When should the firm harvest the bread? The cost of capital for the firm is 14 percent. NPV increase if harvested next year over that of harvesting now NPV increase if harvested year 2 over that of harvesting year 1 NPV increase if harvested year 3 over that of harvesting year 2 NPV increase if harvested year 4 over that of harvesting year 3 NPV increase if harvested year 5 over that of harvesting year 4 A) Harvest now B) Harvest year 2 C) Harvest year 3 D) Harvest year 4 Ans: C

25% 20% 17% 13% 10%

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 77. When to harvest an asset: Farmer Ag owns a special species of cotton-producing plant that, if left unharvested, grows a bigger bowl of cotton through time. The NPV, at the beginning of the year that harvesting takes place, is as follows. When should Farmer Ag harvest its cotton? Assume a discount rate of 14 percent. NPV1 = $50,000 NPV2 = $60,000 NPV3 = $69,000 NPV4 = $77,280 NPV5 = $85,008 A) Harvest now B) Harvest in year 1 C) Harvest in year 2 D) Harvest in year 3 Ans: D Feedback: NPV1 = $50,000 ===> NPV 0,1 = $50,000 / (1.14) = $43,860 NPV2 = $60,000 ===> NPV 0,2 = $60,000 / (1.14)2 = $46,168 NPV3 = $69,000 ===> NPV 0,3 = $69,000 / (1.14)3 = $46,573 NPV4 = $77,280 ===> NPV 0,4 = $77,280 / (1.14)4 = $45,756 NPV5 = $85,008 ===> NPV 0,5 = $85,008 / (1.14)5 = $44,150 The current NPV is maximized with a harvest at year 3.

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 78. When to replace an asset: Nemo Haulers is considering whether to purchase a new mini tractor for moving furniture within its warehouse. Nemo calculates that its current mini tractor generates $3,100 of cash flow per year. A new mini tractor would cost $3,000 and would provide cash flow of $4,000 per year for five years. What is the equivalent annual cash flow for the new mini tractor (round to the nearest dollar), and should Nemo purchase the new tractor? Assume the cost of capital for Nemo is 10 percent. A) $3,000, do not purchase the new tractor B) $3,209, purchase the new tractor C) $4,000, purchase the new tractor D) $12,163, purchase the new tractor Ans: B Feedback:

1   1 − (1.10)5  NPV = −$3, 000 + $4, 000     0.10    0 = −$3, 000 + $15,163 = $12,163  (1 + k )t   (1 + 0.1)5  EAC = kNPV   = 0.1 ( $12,163)    = $3, 209 t 5  (1 + k ) − 1  (1 + 0.1) − 1 , Since this is greater than the annual cash flow of $3,100 produced by the old tractor, the new tractor should be purchased.

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 79. When to replace an asset: Burt's Pizzas is considering whether to purchase an oven. Burt's calculates that its current oven generates $4,000 of cash flow per year. A new oven would cost $15,000 and would provide cash flow of $6,000 per year for six years. What is the equivalent annual cash flow for the new oven (round to the nearest dollar), and should Burt's purchase the new oven? Assume the cost of capital for Burt's is 12 percent. A) $2,352, do not purchase the oven B) $6,000, purchase the oven C) $9,668, purchase the oven D) $24,668, purchase the new oven Ans: A Feedback:

1   1 − (1.12)6  NPV = −$15, 000 + $6, 000     0.12    0 = −$15, 000 + $24, 668 = $9, 668  (1 + k )t   (1 + 0.12 )6  EAC = kNPV   = 0.12  ( $9, 668)    = $2,352 t 6  (1 + k ) − 1  (1 + 0.12 ) − 1 , Since this is less than the annual cash flow of $4,000 produced by the old oven, the new oven should not be purchased.

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 80. The cost of using an existing asset: Small Appliances, Inc., is considering starting a new line of business with the excess capacity it currently has on its rivet machine. The current machine is expected to last four years at the current rate of production. However, if a new line of business is taken on, then the machine will have to be replaced in three years instead of four. A new machine that will last four years would cost $50,000. What is the cost of taking on the new line of business? Round to the nearest dollar and assume a 9 percent cost of capital. A) $11,917 B) $12,500 C) $15,433 D) $50,000 Ans: A Feedback: The EAC for the new machine is

 (1 + k )t   (1 + 0.09 )4  EAC = kNPV   = 0.09  ( $50, 000 )    = $15, 433.43 t 4  (1 + k ) − 1  (1 + 0.09 ) − 1 , now the firm would have to economically incur this additional equivalent cost in year 3. Therefore, the present value of that cost is

$15, 433.43

(1.09 )

= $11,917.44

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Format: Essay Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 81. Briefly explain the two methods of comparing projects with different useful lives. Ans: The first method involves analytically rolling over each project until the two projects have the same number of years in each. It is similar to finding a common denominator when adding fractions. For instance, if one was comparing a two-year and a three-year project, then one could roll the two-year project over two more times until it is a six-year project. At the same time one would roll over the three-year project one more time until it is a six-year project. Once the two projects are both six-year projects, then the NPV of each of the new adjusted projects can then be calculated so that the highest adjusted NPV project would be selected. In the chapter, the second method is called the equivalent annual cost (EAC) method. Using the two projects mentioned above with this method, each project's unadjusted NPV is divided by the appropriate present value interest factor of an annuity

to arrive at the EAC for the project. The project with the greatest positive value should be selected.

Format: Essay Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 82. Explain why in practice the cash flows associated with a project are not certain cash flows. Ans: The projected cash flows on a project are in fact just projects based on estimates of cash flows in different scenarios that might develop over the future. In a best case scenario those cash flows are derived from some probability-based distribution of outcome that will influence either the revenues or expenses, or both, involved in a project. In short, since the cash flows are projects about the future, which is by definition ripe with uncertainty, the projections cannot be 100 percent free of prediction error.

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Format: Essay Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 83. Why is depreciation and amortization added back when calculating free cash flows generated by a project? Ans: Depreciation and amortization is a noncash expense. Since we are interested in the cash flow produced by a project or a firm, then that means that the general income statement approach to calculating profitability has “over” deducted the expenses from a cash perspective. Since this overdeduction helps to reduce the firm's tax bill, it becomes necessary to add back the noncash expenses after taxes have been deducted from the income stream. Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 84. Which of the following statements is correct? A) Incremental net operating profits after-tax should include sunk costs associated with a project. B) Incremental net operating profits after-tax should include the effects of financing costs associated with a project. C) Incremental net operating profits after-tax should exclude the effects of depreciation costs associated with a project. D) Incremental net operating profits after-tax should exclude the effects of financing costs associated with a project. Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 85. Which of the following statements is true? A) The calculation of free cash flow does not include the impact of income taxes. B) Accounting earnings are an unreliable measure of the costs and benefits of a project. C) The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as the incremental principle. D) Depreciation expense should not be included in the calculation of incremental net operating profits after-tax. Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 86. General Mills just is undertaking an analysis on a new cereal. The firm realizes that if they come out with a new product it would affect sales of existing products? What is the best course of action for General Mills in this analysis? A) Treat the reduction of sales from existing cereals as a sunk cost. B) Account for the reduction of sales from existing cereals in the projection of cash flows on the new product. C) Include the allocated costs of the new cereal in the sales of the pre-existing products. D) Ignore the fact that sales of other products will be affected. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Difficult Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 87. Operating Cash Flow: Premier Steel, Inc. is considering the purchase of a new machine for $100,000 that has a useful life of 3 years. The firm’s cost of capital is 11.0% and the tax rate is 40%. This machine will be sold for its salvage value of $20,000 at the end of 3-years. The machine will require an investment of $2,500 in spare parts inventory upon installation. The machine will cost $8,000 to ship and $4,000 to install and modify it. Sales are as follows: year 1 = $90,000; year 2 = $97,500; year 3 = $105,000. Operating expenses are year 1 = $25,000; year 2 = $27,000; year 3 = $29,000. The investment in working capital will be liquidated at termination of the project at the end of year 3. MACRS Rates

33%

45%

15%

Using MACRS, what is the operating cash flow in year 1? A) $53,784 B) $35,238 C) $86,999 D) $42,512 Ans: A Feedback: OPERATING Year Sales Revenues Operating expenses Depreciation Income Before Tax Income Taxes Net income Add: depreciation Project Net Cash Flow

CASH 1 $ 90,000 (25,000) (36,960) 28,040 11,216 16,824 36,960 53,784

Useful Life in Years MACRS Rates

Invoice Cost Shipping Install & Modify Depreciable Cost Basis

$100,000 $ 8,000 $ 4,000 $112,000

33%

FLOWS 2 $97,500 (27,000) (50,400) 20,100 8,040 12,060 50,400 62,460

3 $105,000 (29,000) (16,800) 59,200 23,680 35,520 16,800 52,320

Tax Rate 45%

40% 15% 7%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 88. Average versus Marginal Tax Rate: Suppose Franklin Corporation had pre-tax income of $300,000 in 2010 and that the firm would have paid $100,250.00 in federal income taxes. What is Franklin’s average income tax rate? (Round off to the nearest 0.1%) A) 39.0% B) 34.7% C) 33.4% D) 38.6% Ans: C Feedback:

Average tax rate is equal to total income tax divided by taxable income. Income tax on first $100,000 = $22,250 Income tax on next $200,000 = 39% × ($300,000 - $100,000) = .39 × $200,000 = $78,000 Thus, total tax = $22,250 + $78,000 = $100,250

AverageTaxRate =

IncomeTax $100,250 = = .3342, or33.4% TaxableIncome $300,000

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 89. Which of the following should not be included in a schedule of cash flows from operations when evaluating a capital project? A) Fixed costs. B) Sunk costs. C) Depreciation and amortization. D) Variable costs. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 90. Which of the following is an example of a fixed cost? A) Cost of equipment purchased for an assembly line to be used in the production of a new product. B) Assembly costs associated with the production of a new product. C) Labor costs associated with the production of a new product. D) Shipping costs associated with the sale of a new product. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 91. Your firm is evaluating the merits of several different machines. Machine A has a useful life of 5-years, generates an NPV of $53,250, an IRR of 13.6% and an equivalent annual cost of $10,316. Machine B has a useful life of 3-years, an NPV of $61,051, an IRR of 12.5%, and an equivalent annual cost of $9,724. Machine C has a useful life of 4-years, generates an NPV of $55,225, an IRR of 15.2% and an equivalent annual cost of $7,535 Machine D has a useful life of 7-years, generates an NPV of $64,020, an IRR of 11.4% and an equivalent annual cost of $8,885. Which machine should be purchased and why? A) Machine C, because it has the highest IRR. B) Machine D, because it has the highest NPV. C) Machine A, because it has the most positive EAC D) Machine B, because it has the shortest useful life. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 92. Equivalent Annual Cost: Your firm is considering an investment that will cost $750,000 today. The investment will produce cash flows of $250,000 in year 1, $400,000 in year 2, and $600,000 in year 3. The discount rate that your firm uses for projects of this type is 11.75%. What is the investment's equivalent annual cost? (Round off to the nearest whole dollar) A) $163,613 B) $225,008 C) $68,888 D) $92,845 Ans: D Feedback: Equivalent Annual Cost PV of

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Fundamentals of Corporate Finance 3e

Year 0 1 2 3

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Estimated Cash Flows at Cash Flows 11.75% ($750,000) 250,000 223,714 400,000 320,306 600,000 429,941 Total PV of CF's $973,960 Minus Cost ($750,000) Net Present Value $223,960 EAC $92,845 Discount Rate 11.75%

PV = $223,960; N = 3, I% = 11.75%; Thus PMT (EAC) = $92,845

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Investment Decisions AICPA: Industry/Sector Perspective 93. When is the appropriate time to harvest an asset? A) That point in time where harvesting the asset yields the largest internal rate of return. B) That point in time where harvesting the asset yields the smallest payback. C) That point in time where harvesting the asset yields the largest accounting rate of return. D) That point in time where harvesting the asset yields the largest net present value. Ans: D

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Fundamentals of Corporate Finance 3e

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Chapter 12: Evaluating Project Economics Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 1. Total variable costs for a firm do not vary directly with the number of units sold. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comrpehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 2. A project with a higher proportion of fixed costs will have cash flows and accounting profits that are more sensitive to changes in revenues than an otherwise identical project with a lower proportion of fixed costs. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 3. A synonym for pretax operating cash flow is EBIT. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 4. Distinguishing between fixed and variable costs will enable one to calculate the sensitivity of EBITDA to changes in revenue. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 5. EBITDA is more sensitive to changes in revenue than EBIT. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 6. Depreciation and amortization can be considered a fixed cost of the firm, for accounting breakeven purposes. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 7. Operating leverage is a measure of the sensitivity of net income to changes in revenue. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehensnion AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 8. The degree of pretax cash flow operating leverage will change for different levels of revenue. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 9. If a firm's degree of accounting operating leverage is 1.12, a 10 percent increase in revenue should result in a 12.0 percent increase in EBIT. A) True B) False Ans: B Feedback: 1 percent increase in revenue will result in a 1.12% change in EBIT. Hence, for 10% change in revenue, the increase in EBIT = 10% × 1.12 = 11.2%

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 10. If Tunemony Craft had an increase in EBIT of 24 percent with an degree of accounting operating leverage of 1.2, then the firm must have had a 20 percent increase in revenue if no other changes were involved. A) True B) False Ans: A Feedback: When EBIT had an increase of 24%, the increase in revenue = 24% ÷ 1.2 = 20%

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 11. If The Tower of Pizza has a cash flow degree of operating leverage equal to 1.15, then a 20 percent increase in revenue should drive a 35 percent increase in pretax operating cash flow. A) True B) False Ans: B Feedback: 1 percent change in revenue will result in 1.15% increase in the pretax operating cash flow. Hence, for 20% increase in revenue, the increase in the pretax operating cash flow = 20% × 1.15 = 23%.

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 12. Taxes do not enter into the equation for the degree of cash flow of operating leverage because both fixed costs and pretax operating cash flows are measured on a pretax basis. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 13. If there is no uncertainty regarding costs, volatility in pretax operating cash flows and accounting operating profits will be driven entirely by changes in revenue and operating leverage. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 14. Operating profits and operating cash flow describe the same item. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 15. A firm that has zero fixed costs will have a degree of cash flow operating leverage equal to one. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 16. An increase in the proportion of a project's costs that are fixed will increase the degree of operating leverage for the project. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 17. Break-even analysis tells us how many units must be sold in order for a project to break even on a cash flow or an accounting basis. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 18. If a project fails to break even from a pretax operating cash flow perspective, then the firm is going to put more cash into the project to keep it going. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 19. The pretax operating cash flow (EBITDA) break-even point is determined by how many units will have to be sold in order to cover the firms fixed cash expenses. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 20. The per-unit contribution margin is defined as the total sales price less its total variable cost. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 21. The crossover level of unit sales is the level at which one fixed/variable cost combination of production will begin to generate higher levels of operating cash flows than another fixed/variable cost combination of production. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 22. The crossover level of unit sales can be calculated for any two alternatives that have the same level of operating leverage. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 23. The accounting operating profit (EBIT) break-even point tells us how many units must be sold to avoid an accounting operating loss. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 24. The accounting operating profit break-even points are smaller than the corresponding pretax operating cash flow break-even points for a project with positive costs. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 25. An economic break-even point is the number of units that must be sold each year during the life of the project so that the difference of present value of cash inflows and present value of cash outflows is one. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 27. The economic break-even point focuses on the cash flows or profits from operations rather than after-tax free cash flows associated with the project. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 28. The NPV of a project will equal $0 when the present value of the annual FCFs from the project, PV (FCF), equals the present value of net nonrecurring investments. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 29. An analysis in which a firm would like to know the effect of a price change on the NPV of a project, holding all other variables and forecasts constant, is one type of sensitivity analysis. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 30. If a firm knows that a price change will have an effect on a number of other forecast variables, such as the sales forecast, then the firm might require scenario analysis rather than sensitivity analysis. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 31. Within a simulation analysis, the firm will need to come up with some distributional assumptions concerning the forecast inputs, such as the mean and variance of the sales forecast. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 32. Simulation analysis has the benefit of providing a pinpoint accurate forecast of a project's NPV. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 33. Sensitivity analysis involves examining the sensitivity of the output from an analysis, such as the NPV to changes in individual assumptions. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 34. The economic break-even point focuses on the after-tax free cash flows associated with the project for its entire life. A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 35. EBITDA stands for: A) earnings before interest, taxes, and amortized depreciation. B) earnings before interest, taxes, depreciation, and amortization. C) earnings before interest and taxes. D) earnings before interest, taxes, dividend, and accrued expenses. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 37. Another name for EBITDA is: A) pretax operating cash flow. B) accounting operating cash flow. C) net income before tax. D) net income after tax. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 38. Compared to an identical project with a lower proportion of fixed costs, a project with a higher proportion of fixed costs will have: A) a higher degree of sensitivity of EBITDA to a change in revenues. B) a lower degree of sensitivity of EBITDA to a change in revenues. C) no discernible difference of a change in sensitivity of EBITDA to a change in revenues. D) a stable net income stream as a function of revenues. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 39. If a firm is about to operate in an environment in which there will be a great deal of variability in the level of revenues, then the firm: A) should structure its cost structure to have high fixed costs and higher total variable costs. B) should structure its cost structure to have high fixed costs and consequently lower per unit variable costs. C) should structure its cost structure to have low fixed costs and consequently higher per unit variable costs. D) should leave the cost structure unchanged. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 40. The degree of pretax cash flow operating leverage provides us with: A) a measure of how sensitive pretax operating cash flows are to changes in revenue. B) a measure of how sensitive accounting operating profits are to changes in revenue. C) a measure of how sensitive NOPAT is to changes in tax rates. D) a measure of how sensitive accounting operating profits are to changes in tax rates. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 41. _____ is a measure of the sensitivity of EBITDA or EBIT to changes in revenue. A) Total leverage B) Financial leverage C) Operating leverage D) Combined leverage Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 42. Depreciation and amortization are treated like fixed costs: A) in the calculation of the degree of pretax cash flow operating leverage. B) in the calculation of the degree of accounting operating leverage. C) for cash flow purposes. D) for computing dividend. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 43. If the degree of accounting operating leverage is 1.3 for a firm, then a 10 percent increase in revenue should drive a: A) 12% increase in pretax operating cash flows. B) 13% increase in EBIT. C) 30% increase in EBIT. D) 1.3% increase in pretax operating cash flows. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 44. Which of the following statements is true? A) The degree of pretax cash flow operating leverage remains same for any level of revenue. B) The higher the proportion of fixed costs to variable costs in a project, the greater the sensitivity of pre-tax operating cash flows to changes in revenue. C) Depreciation and amortization are deducted to get pretax operating cash flows. D) The lower the proportion of fixed costs to variable costs in a project, the more pre-tax operating cash flows will vary as revenue varies. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 45. The higher a project’s operating leverage, _____. A) the lower the sensitivity of EBIT to changes in revenue B) the greater the sensitivity of EBITDA to changes in revenue C) the lower the sensitivity of net profit to changes in variable costs D) the greater the sensitivity of net profit to changes in variable costs Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 46. Which is the term used to define how many units must be sold for pre-tax operating cash flow to be equal to zero? A) Pre-tax accounting operating profit break-even point B) Pre-tax operating financial leverage break-even point C) Pre-tax accounting sensitivity break-even point D) Pre-tax operating cash flow break-even point Ans: D Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 47. Which of the following differentiates accounting operating profit break-even point from pre-tax operating cash flow break-even point? A) Accounting operating profit break-even point includes interest expense in the numerator, whereas pre-tax operating cash flow does not. B) Pre-tax operating cash flow break-even point includes income taxes in the denominator, whereas accounting operating profit break-even point does not. C) Accounting operating profit break-even point includes depreciation & amortization in the numerator, whereas pre-tax operating cash flow does not. D) Pre-tax operating cash flow break-even point includes interest expense in the numerator, whereas accounting operating profit break-even point does not. Ans: C Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 48. The economic break-even point is the number of units that must be sold each year over the life of a project in order for the NPV of that project to equal to _____. A) $0 B) $1 C) the present value of cash inflows D) the present value of investment Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 49. The difference between revenue and variable cost is called: A) total contribution. B) net profit. C) EBIT. D) EAT. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 50. Which of the following statements is true of the economic break-even point? A) It is the number of units that must be sold for accounting operating profit to equal $0. B) It is the level of unit sales at which cash flows or profitability for one project alternative switches from being lower than that of another alternative to being higher. C) It is the number of units that must be sold each year during the life of a project so that the NPV of a project equals $0. D) It is the number of units that must be sold for pretax operating cash flow to be $0. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 51. Sancore Inc. decided to invest in a project costing $35,000. It is assumed that all of $8,000 working capital will be recovered at the end of the project, which is four years. The opportunity cost of capital is 10%. Compute the present value of net non-recurring investment of the project. (Do not round intermediate calculation. Round the final answer to the nearest dollar.) A) $36,713 B) $45,657 C) $46,713 D) $35,657 Ans: C Feedback: PV(Net Non-Recurring Investments) = $35,000 + $8,000 (1.1)4 = $46,713

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 52. Astroscope Tours finds that if it were to increase its price by 10 percent, it would have a 6 percent reduction in the NPV of its new 3-Hour Tour. Considering other things to be unchanged, Astroscope's analysis could be described as: A) Monte Carlo simulation. B) break-even analysis. C) sensitivity analysis. D) variance analysis. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 53. If a firm were interested in knowing the effect of a single input change on the net present value of a project, then the firm would most likely want to perform: A) a Monte Carlo simulation. B) a scenario analysis. C) a sensitivity analysis. D) a break-even analysis. Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 54. If a firm wanted to find the effect of a change in the variable cost per unit of production on the net present value of a project, then the firm might perform: A) a sensitivity analysis. B) a scenario analysis. C) a Monte Carlo simulation. D) a cash flow simulation. Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 55. At times, when a firm is considering an alternative such that a set of variables affecting a project are interrelated, then analysis that considers this interrelation could be performed. This is called: A) a sensitivity analysis. B) a scenario analysis. C) a Monte Carlo simulation. D) a horizontal analysis. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 56. A firm is considering two distinct set of circumstances that assume high inflation and low inflation. In the high inflationary set of circumstances, the price per unit will be affected as well as the variable and fixed costs. If the low-inflation set of circumstances is considered the baseline, then the analysis concerning the high inflationary circumstances could be considered: A) a sensitivity analysis. B) a scenario analysis. C) a Monte Carlo simulation. D) a horizontal analysis. Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 57. Scenario analysis can help a firm to: A) understand the degree of uncertainty that a different set of project-affecting circumstances may hold. B) eliminate all of the uncertainty that a different set of project-affecting circumstances may hold. C) transform a risky project into a risk-free project. D) understand the degree of certainty that a similar set of project-affecting circumstances may hold. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 58. If a project holds an 80 percent probability of high demand and a 20 percent probability of low demand, then the expected value of the net present value of the two different demand assumptions would give us a weighted average net present value for the project. Such an analysis is called: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 59. An analysis in which each of the inputs and assumptions for a project takes on a separate assumed distribution whereby a computer draws on each of those input and assumption distributions to create a distribution for the NPV of the entire project is called: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: ComprehensApplicationion AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 60. Ottomony has analyzed a new type of all-in-one retail center where the NPV of the project has an expected value with a distribution that yields a standard deviation of $25 million. Ottomony came to this conclusion by analyzing the individual input distributions for the project. This analysis is called: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 61. If a firm is interested in the distribution of the NPV for a project that it is considering, then the firm should be most interested in: A) a sensitivity analysis. B) a scenario analysis. C) a simulation analysis. D) a horizontal analysis. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 62. Which of the following mathematical expressions is used to calculate the degree of pretax cash flow operating leverage? A) 1 + (FC / EBITDA) B) 1 + (FC / EBIT) C) 1 + [(FC + Depreciation and Amortization) / EBITDA] D) 1 + [(FC + Depreciation and Amortization) / EBIT] Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 63. Which of the following project risk analyses is best able to analyze the effect of a single input, uncorrelated with other inputs, on the NPV of a project? A) Sensitivity analysis B) Scenario analysis C) Simulation analysis D) Horizontal analysis Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 64. Which of the following project risk analyses is best able to analyze the effect of a single set of circumstances, with correlated inputs, on the NPV of a project? A) Sensitivity analysis. B) Scenario analysis. C) Simulation analysis. D) Contribution analysis. Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 65. A change in sales price of a product sold by a firm will probably involve a reduction in the number of units sold, as well as the possibility of a change in the cost structure of the firm's product in question. If a firm were interested in the entire price change effect on the NPV of a project, then it would be interested in: A) sensitivity analysis. B) scenario analysis. C) simulation analysis. D) contribution analysis. Ans: B

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 66. An analytical method that uses a computer to quickly examine a large number of scenarios and obtain probability estimates for various values in a financial analysis is known as: A) risk analysis. B) credit analysis. C) capital structure analysis. D) simulation analysis. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 67. Which of the following mathematical expressions is used to calculate the degree of accounting operating leverage? A) 1 + (FC / EBITDA) B) 1 + (FC / EBIT) C) 1 + [(FC + Depreciation and Amortization) / EBITDA] D) 1 + [(FC + Depreciation and Amortization) / EBIT] Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 68. Sparran Craft had sales of $2.24 million last year for which the total cost was $2 million. If the firm had fixed costs of $600,000 on sales of 56,000 books, then what is the firm's per-unit contribution? (Round the final answer to the nearest whole dollar.) A) $20.00 B) $19.00 C) $15.00 D) $10.00 Ans: C Feedback: Unit sales = 56,000 units Sales = $2,240,000 Total fixed costs = $600,000 Total variable costs = Total costs –Total fixed costs = $2,000,000 – $600,000= $1,400,000 Unit variable costs = $1,400,000 / 56,000 = $25.00 per unit Sale price/unit = $2,240,000 / 56,000 = $40 per unit Unit contribution margin = $40.00 – $25.00 = $15.00

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 69. Oeta Works has a degree of pretax cash flow operating leverage of 1.25. If the firm's EBITDA was $1,000 last year while its depreciation and amortization expense was $50 in the same year, then what was the firm's degree of accounting operating leverage? A) 1.26 B) 1.30 C) 1.32 D) 1.35 Ans: C Feedback:

1+ Degree of pretax cash flow operating leverage =

1.25 = 1 +

FC  FC = $250 $1, 000 1+

FC + D & A EBITDA − D & A

$250 + $50 = 1.315789  1.32 $1, 000 − $50

Degree of accounting operating leverage =

FC EBITDA

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 70. Synthgration has a degree of pretax cash flow operating leverage equal to 1.266. If the firm's EBITDA was $1,500 last year while its depreciation and amortization expense was $100 in the same year, then what was the firm's degree of accounting operating leverage? A) 1.29 B) 1.33 C) 1.36 D) 1.39 Ans: C Feedback:

1+ Degree of pretax cash flow operating leverage =

1.266 = 1 +

FC  FC = $399 $1,500 1+

FC + D & A EBITDA − D & A

$399 + $100 = 1.35642857  1.36 $1,500 − $100

Degree of accounting operating leverage =

FC EBITDA

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 71. Mussubsound Audotec Inc. had EBIT of $1,850 last year with fixed costs equal to $500 (depreciation and amortization not included) and depreciation and amortization equal to $150. What was Mussubsound Audotec's degree of accounting operating leverage? A) 1.25 B) 1.35 C) 1.38 D) 1.40 Ans: B Feedback:

Degree of accounting operating leverage = 1 +

FC + D & A FC + D & A = 1+ EBITDA − D & A EBIT

= =

1.35

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 72. Dupaudio Inc. had EBITDA of $3,000 and EBIT of $2,750, with fixed cash expense of $600 last year. What was Dupaudio's degree of accounting operating leverage? A) 1.20 B) 1.25 C) 1.28 D) 1.31 Ans: D Feedback: EBITDA = $3,000 and EBIT = $2,750 ==> D&A = $250

Degree of accounting operating leverage = 1 +

FC + D & A FC + D & A = 1+ EBITDA − D & A EBIT

1.31

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 73. Metkia Inc. had a degree of accounting operating leverage equal to 1.841 during the most recent period. If the firm's EBITDA was $4,800 and depreciation and amortization was equal to$600, then what was Metkia's fixed cash expenses during the same period? (Round your answer to the nearest whole dollar.) A) $1,548 B) $2,932 C) $2,324 D) $2,886 Ans: B Feedback:

FC + D & A EBITDA − D & A = 1.841 Degree of accounting operating leverage = FC + $600 1 + $4,800 – $600 = 1.841 Degree of accounting operating leverage = 1+

FC = $2,932.2

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 74. Ergotone Audio had a degree of accounting operating leverage equal to 1.60 during the most recent period. If the firm's EBITDA was $3,000 and its fixed costs were equal to $1,250, then what was Ergotone 's depreciation and amortization expense during the same period?(Round the final answer to the nearest whole dollar.) A) $344 B) $507 C) $377 D) $404 Ans: A Feedback:

FC + D & A EBITDA − D & A Degree of accounting operating leverage = $1,250 + D & A 1+ $3,000 – D & A Degree of accounting operating leverage = 1+

= 1.60 = 1.60

D & A = $343.75

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 75. Resoneffect Inc. has a degree of pretax cash flow operating leverage equal to 1.12. If the firm's EBITDA was $2,000 last year while its depreciation and amortization expense was $150 in the same year, then what was the firm's degree of accounting operating leverage? (Round the final answer to two decimal places.) A) 1.09 B) 1.21 C) 2.09 D) 2.18 Ans: B Feedback:

1+ Degree of pretax cash flow operating leverage =

1+ Degree of accounting operating leverage =

FC EBITDA

FC + D & A EBITDA − D & A

Degree of accounting operating leverage =

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 76. Silevector has a degree of pretax cash flow operating leverage equal to 1.341. If the firm's EBITDA was $2,500 last year while its depreciation and amortization expense was $200 in the same year, then what was the firm's degree of accounting operating leverage? (Do not round the intermediate calculations. Round your final answer to two decimal places) A) 2.54 B) 1.96 C) 1.46 D) 2.39 Ans: C Feedback:

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 77. Treguard Inc. has total fixed costs of $8,500 per month. It sells rib plates for $15 each and the variable cost of providing each plate is $10. What is the pretax operating cash flow break-even point for Treguard? A) 567 plates B) 1,700 plates C) 1,900 plates D) 1,622 plates Ans: B Feedback:

EBITDA Break − Even =

FC $8,500 = = 1, 700 Pr ice − Unit VC $15 − $10

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 78. SileCuatro has produced 22,000 tins in a year. The pretax operating cash flow (EBITDA) break-even point is 22,000 tins. If the fixed costs for the product is $1,500,000 and the variable cost per tin is $298, then what price can SileCuatro charge per tin if the firm needs to break even on a pretax operating cash flow basis? (Round to nearest whole dollar.) A) $366 B) $298 C) $268 D) $372 Ans: A Feedback: FC EBITDA Break-even = Price – Unit VC $1,500,000 22,000 = Price – $298 = Price $366.18

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 79. AchtTre has found that its pretax operating cash flow basis break-even number of glasses sold is 550,000 pairs. If each pair is sold for $15 and the variable cost per unit is $10, then what is the amount of AchtTre's fixed costs? A) $887,000 B) $1,558,000 C) $2,750,000 D) $1,582,000 Ans: C Feedback: FC EBITDA Break ̶ even = Price – Unit VC FC 550,000 = $15 – $10 = FC $2,750,000

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 80. Ranbow Inc.is about to introduce a new LED clock and has determined that it will charge $35 per clock. The firm must decide whether or not to purchase a high-capacity clock-making machine. If the high-capacity machine is selected, then the fixed costs for the firm will be $4,000 per year, with variable costs of $6 per clock. Otherwise the fixed costs will be $800, with variable costs of $16 per clock. Above what level of expected sales should Ranbow Inc. choose the high fixed cost alternative to maximize pretax operating cash flow? A) 320 units B) 352 units C) 3200 units D) 500 units Ans: A Feedback: COEBITA

FCAlt 1 – FCAlt 2 Unit ContributionAlt 1 – Unit ContributionAlt 2 $4,000 – $800 $29 – $19 = 320 units

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

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Fundamentals of Corporate Finance 3e

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Feedback: COEBITA

FCAlt 1 – FCAlt 2

1,000

Unit ContributionAlt 1 – Unit ContributionAlt 2 $12,000 – $3,000

($66 – $33)

Unit ContributionAlt 2

–

Unit ContributionAlt 2

= $24

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

FCAlt 1 – FCAlt 2

= =

Unit ContributionAlt 1 – Unit ContributionAlt 2 $11,000 – $2,500 ($62 – $32) – Unit ContributionAlt 2

Unit ContributionAlt 2 = $20 VClow capacity = $62 – $20 = $42

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 83. A cement contractor has determined that he will maximize pretax operating cash flow buying a large cement truck if he is able to sell more than 550 yards of cement per month. The price of a yard of cement is $62, and the variable costs for a large truck are $22 per yard. The variable costs for a small truck are $44 per yard, and the fixed costs for the small truck are $12,000. What are the fixed costs associated with the large truck? A) $20,000 B) $12,000 C) $24,100 D) $35,000 Ans: C Feedback:

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 84. CoTres's Brakes is introducing a new revolutionary brake-pad for vehicles that will never wear out. CoTres's will sell the pads for $150 a pair and they will cost $100 in variable costs to produce. If cash fixed expenses are $2,500 per year and the depreciation and amortization expenses are $900 per year, then what is the accounting operating profit break-even point for the company? A) 86 pairs B) 28 pairs C) 57 pairs D) 68 pairs Ans: D Feedback:

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 85. Mexmagnet is introducing a new game system that promises to never become outdated. Mexmagnet will sell the systems for $225, and it will accrue $150 in variable costs to produce. If cash fixed expenses are $30 million per year and the depreciation and amortization expenses are $7.5 million per year, then what is the accounting operating profit break-even point for Mexmagnet? A) 621,000 units B) 415,077 units C) 200,000 units D) 500,000 units Ans: D Feedback:

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 86. EpicSept is about to introduce a new employee monitoring tool and has determined that it will charge $100 per unit. The firm must decide whether or not to purchase a high-capacity manufacturing machine. If the high-capacity machine is selected, then the cash fixed costs will be $5,000 per year, with variable costs of $50 per unit and depreciation and amortization expenses of $2,000. Otherwise the fixed costs will be $2,000, with variable costs of $75 per unit and depreciation and amortization expenses of $500. If EBIT Break-even is how the firm evaluates its projects, then above what level of expected sales should EpicSept choose the high fixed cost alternative? A) 60 units B) 90 units C) 120 units D) 180 units Ans: D Feedback: ( FC + D & A) Alt1 − ( FC + D & A) Alt 2 ($5, 000 + $2, 000) − ($2, 000 + $500) COEBIT = = = 180 tools (Unit ContribAlt1 − Unit ContribAlt 2 ) $50 − $25

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 87. Sechssonic has found that it is indifferent between purchasing a high-capacity vacuum sealing machine or a lower capacity machine as long as sales are 200 units per month. The price of each sealed beam light is $50. The high-capacity machine has cash expenses of $10,000 per month, while the other alternative has cash expenses of $5,000 per month and depreciation and amortization expenses of $2,000 per month. Under high capacity, the variable costs per unit are $10; and they are $40 for the other alternative. If the firm bases its decisions on the accounting operating profit break-even, then what are the depreciation expenses under the high-capacity alternative? A) $3,000 B) $4,000 C) $9,000 D) $5,000 Ans: A Feedback: COEBIT =

( FC + D & A) Alt1 − ( FC + D & A) Alt 2 ($10, 000 + D & AAlt1 ) − ($5, 000 + $2, 000) = 200 units =  (Unit ContribAlt1 − Unit ContribAlt 2 ) $40 − $10

D & AAlt1 = $3, 000

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 88. SeptSeven has found that it is indifferent between purchasing a high-capacity vacuum component assembly machine or a lower capacity machine as long as sales are 1,900 units per month. The price of each calculator is $70. The high-capacity machine has cash expenses of $100,000 per month and depreciation and amortization expenses of $30,000 per month, while the alternative has cash expenses of $30,000 per month and depreciation and amortization expenses of $5,000 per month. Under the low-capacity alternative, variable costs per unit are $60. If the firm bases its decisions on the accounting operating profit break-even, then what is the variable cost per unit under the high-capacity alternative? A) $10 B) $47 C) $60 D) $70 Ans: A Feedback: COEBIT =

( FC + D & A) Alt1 − ( FC + D & A) Alt 2 ($100, 000 + $30, 000) − ($30, 000 + $5, 000) = 1,900 units =  (Unit ContribAlt1 − Unit ContribAlt 2 ) Unit ContribAlt1 − $10

Unit ContribAlt1 = $60  Unit VC = $10

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 89. OutCinq manufactures snow boards. The firm has fixed costs of $1,500,561. The snow boards sell for $235 each and have a variable cost of $92 each. What is the pretax operating cash flow break-even point for OutCinq? (Round to the nearest unit) A) 9,566 units B) 10,493 units C) 11,565 units D) 6,565 units Ans: B Feedback: EBITDA Break- even

= = =

FC Price – Unit VC $1,500,561 $235 – $92 10,493.43

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 90. Cino Inc. earned from its brake pads manufacturing unit revenue of $560,000 and depreciation and amortization for the unit was $50,000. The company sells its product to customers at a price of $100. Further, the financial statement reveals that the EBIT for the year was $80,000. The variable cost for each unit of brake pad is $60. What is the amount of fixed cost that leads to the EBIT as provided in the financial statement? A) $88,000 B) $90,000 C) $94,000 D) $105,000 Ans: C Feedback: EBIT = Revenue – VC – FC – D & A $80,000 = $560,000 – ($60 × 5,600 units) – FC – $50,000 FC = $94,000

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 91. The management Dior Corp. is planning to invest in a machine which has a four-year life. The initial investment of the project is $8,000, the annual addition to working capital is equal to $4,000. The fixed cost would be $4,000. The unit contribution margin is $15. The firm’s marginal tax rate is 35%. The present value of net non-recurring investments would be $18,928. FCFt is $5,971.Compute the economic break even. (Round your intermediate calculation to whole dollar amount and final answer to the nearest whole unit.) A) 1,218 units B) 1,305 units C) 1,280 units D) 1,880 units Ans: A Feedback: EBITt = (FCFt – D&At + Cap Expt + Add WCt ) ÷ (1 – t) = ($5,971 – $2,000 + $0 + $4,000) ÷ (1 – 0.35) = $12,264 Revenuet – VCt = EBITt + D&At + FCt = $12,264 + $2,000 + $4,000 = $18,264 Economic Break-EvenT = (Revenue – VC) / Unit contribution = $18,264 / $15 = 1,218 units

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Format: Essay Learning Objective: LO 2 Level of Difficulty: Analysis Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 92. Briefly explain the difference between the degree of pretax cash flow operating leverage and the degree of accounting operating leverage. Also explain why someone might be interested in one or the other. Ans: The formulas for the two are as follows:

The degree of pretax cash flow operating leverage considers pretax operating cash flows (EBITDA), while the degree of accounting operating leverage considers accounting operating profits (EBIT). Since the difference between EBITDA and EBIT is depreciation and amortization, it is apparent that the accounting method considers a measure of pretax income that has depreciation and amortization removed from the starting point. However, since pretax cash flow does not include noncash items, such as depreciation and amortization, it does not consider those items. If, however, a firm is replacing depreciated assets, then the accounting method might actually serve as a good measure of pretax cash flow.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 93. Soleon, Inc. had the following financial data for the fiscal year ending September 30, 2014. Sales $1,937,813 Depreciation and amortization $70,657 Fixed costs $132,456 Earnings before interest and taxes $564,441 Calculate the firm's degree of pre-tax cash flow operating leverage during fiscal 2014? A) 1.21 B) 1.46 C) 1.17 D) 1.85 Ans: A Feedback:

DegreeOf Pr e − taxOperatingLeverage = 1 +

FixedCosts FC =1+ Pr e − taxOperatingCashFlows EBITDA

Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 94. Briefly discuss the advantages of knowing the economic break-even point. Ans: The economic break-even point accounts for both taxes and investment associated with the project hence they are more comprehensive measures. The economic break-even point help a financial manager assess the overall economic viability of a project. This measure tells the manager how low unit sales can get before a project destroys stockholder value.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysi AASCB: Analytic IMA: Business Economics AICPA: Industry/Sector Perspective 95. Discuss the differences between scenario analysis and sensitivity analysis. Ans: Sensitivity analysis is an examination of the sensitivity of the results from a financial analysis to changes in individual assumptions. Scenario analysis an analytical method concerned with how the results from a financial analysis will change under alternative scenarios. In sensitivity analysis, an analyst might examine how a project’s NPV changes if there is a decrease in the value of individual cash inflow assumptions or an increase in the value of individual cash outflow assumptions. A scenario analysis helps in examining how the attractiveness of the project might vary under different economic scenario.

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Chapter 13: The Cost of Capital

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Systematic risk is the only risk that investors require compensation for bearing. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Using a firm's overall cost of capital to evaluate a project's cash flows is problematic in that the firm is a collection of projects, with the possibility that each project has a different level of risk than the other projects currently working for the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The finance balance sheet is based on market values, just like the accounting balance sheet. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If the market value of a firm's assets is greater than the book value of its assets then the book value of the firm's liabilities and equity must be less than the market value of the firm's liabilities and equity. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The beta of a firm is equal to the weighted-average sum of the betas of the individual projects that the firm is currently operating. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Due to the magic of diversification, the risk associated with the assets of a firm must be less than the risk associated with the financing, or debt and equity that a firm is utilizing for its assets. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

10.

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective A firm is currently taking on two projects with an individual cost of capital of 10 percent and 12 percent for each of the projects. This means that the before-tax cost of capital for the firm must be between 10 and 12 percent. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If a firm finances the purchase of an asset with cash, then it has zero financial cost to the firm. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If one observes the market quoted price of a debt security where the expected cash flows of that security are known, then one can calculate the current cost of that security to the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Long-term debt typically describes debt that will mature in two years or more. A) True B) False Ans: A

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11.

12.

13.

14.

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Long-term debt is generally viewed as a permanent financing source for a firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective With respect to the cost of capital, we are generally interested in the cost of a source of financing on a particular date. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The historic cost of long-term debt is the appropriate cost of debt for WACC calculations. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Milton Corp. issued bonds 10 years ago with a coupon rate of 10 percent at a price of $1,000. The current price of the bonds is $980. The before-tax cost of the debt to the firm is still 10 percent. A) True B) False Ans: A

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15.

16.

17.

18.

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The yield to maturity for an annual coupon paying bond will always be equal to the coupon rate. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The yield to maturity is the discount rate that makes the present value of coupon and principal payments equal to the price of the bond. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The current cost of bank debt of a firm can be determined by asking the firm's banker. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If a firm is subject to income taxes, then the after-tax cost of debt for the firm will be less than the before-tax cost of debt. A) True B) False Ans: A

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19.

20.

21.

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Format: True/False Learning Objective: LO 2 Level Of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The issuance costs of new debt securities can be ignored since those costs will not be reflected in the yield to maturity of the debt in the future. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Utilizing the CAPM to estimate the cost of capital for a project is difficult in practice because analysts do not have the stock returns from individual projects that are necessary to use in a regression analysis for estimating a project's beta. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Estimates of expected returns based on market security prices will be reliable in all types of markets, including those deemed less efficient than others. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

22.

23.

24.

25.

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The cost of equity for a firm must take the cost of preferred stock (if any has been issued) that the firm has outstanding into account. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective When trying to estimate the cost of equity for a firm using the CAPM, it is possible to find the beta of a comparable, publicly traded firm whose primary business is closely related to the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The market risk premium for the future is always perfectly known, and it is 6.51 percent. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

26.

27.

28.

29.

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If a firm is currently paying common share dividends to investors and those dividends are expected to grow at a low but steady rate in the future, then the cost of common equity for the firm can be determined by also using the current price of the firm's common shares. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The current cost of preferred equity can be found by taking the ratio of the annual dividend on the preferred stock to the current price of preferred shares. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The CAPM can only be used to determine the cost of common equity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The proportions of debt and equity used to determine the weighted average cost of capital for a firm is based on the market value of debt and equity outstanding. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

30.

31.

32.

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The correctly calculated weighted average cost of capital for a firm can be used to discount the cash flows for any new project that the firm may undertake in the future. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The estimated cost of capital the financial manager use for efficiency projects tends to be higher than the cost of capital used to evaluate new projects. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective When using a single rate, such as the WACC, to discount cash flows for all projects of a particular company, the discount rate could lead to accepting projects that will actually have a negative NPV. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

33.

34.

35.

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Format: Multiple choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If a company's weighted average cost of capital is less than the required return on equity, then the firm A) is financed with more than 50% debt. B) is perceived to be safe. C) has debt in its capital structure. D) must have preferred stock in its capital structure. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Firms have no way to directly estimate the discount rate that reflects the risk of A) a publicly traded security. B) its debt securities. C)

the incremental cash flows from a particular project.

D) Ans:

None of the above C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective A firm's overall cost of capital is A) less than its cost of debt. B) a weighted average of the costs of capital for the collection of individual projects that the firm is working on. C)

best measured by the cost of capital of the riskiest projects that the firm is working on.

D) Ans:

None of the above B

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Fundamentals of Corporate Finance 3e

36.

37.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The finance balance sheet is A) the same as the accounting balance sheet, but it is based on market values. B) the same as the accounting balance sheet, but it does not have to balance. C) based on cash rather than accrual accounting. D) the same as the accounting balance sheet, but it is based on historical values. Ans: A

38.

Test Bank

the value of the cash flows claimed by the equity investors. the value of the cash flows claimed by the debt investors. the value of the cash flows claimed by both the equity and debt investors. the revenue produced by the firm. C

adding up the betas of the individual projects of the firm. taking the weighted average of the beta for the individual projects of the firm.

C) D) Ans:

taking the simple average of the beta for the individual projects of the firm. None of the above B

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Fundamentals of Corporate Finance 3e

39.

a portfolio of individual projects, each with its own risks, cost of capital, and returns.

a collection of equity shares comprising it.

C) D)

a collection of debt instruments financing it. a portfolio of all individual projects in the industry, each with its own risks, cost of capital, and returns. A

Ans:

40.

41.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective In order for a firm to estimate its cost of debt capital by observing the price of its debt instruments, A) the firm must depend on markets being reasonably efficient. B) the debt must be privately held by the firm. C) the beta of the debt must be greater than the beta of the firm's equity. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If markets are not reasonably efficient, then A) the estimates of expected returns are not needed. B) the need for a discount rate to analyze project cash flows is not needed. C) estimates of expected returns based on security prices will not be reliable. D) None of the above Ans: C

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43.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective When estimating the cost of debt capital for a firm, we are primarily interested in A) the weighted average cost of capital. B) the cost of long-term debt. C) the coupon rate of the debt. D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Long-term debt typically describes A) debt with a maturity greater than one year. B) only coupon debt. C) publicly traded debt. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Which of the following need to be excluded from the calculation of a firm's amount of permanent debt? A) Long-term debt B) Revolving lines of credit C) Mortgage debt D) None of the above Ans: B

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45.

46.

47.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective When analyzing a firm's cost of debt, we are typically interested in A) the cost of the debt on the date that the analysis is being completed. B) the coupon rate on the firm's bonds. C) the cost of the debt and cost of preferred stock on the date that the analysis is being completed. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective If a firm has bonds outstanding and the firm would like to calculate the current cost of debt for the bonds, then the firm would A) use the coupon rate of the bonds to estimate the cost. B) use the current yield to maturity of the bonds to estimate the cost. C) use the current coupon yield of the bonds to estimate the cost. D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Appllication AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective A bond has a coupon rate of 6 percent and the bond makes semiannual coupon payments. The dollar amount of coupon interest received every six months is A) $60. B) $30. C) $30 plus or minus the prorate portion of the discount or premium that the bond was purchased for. D) $60 plus or minus the prorate portion of the discount or premium that the bond was purchased for. Ans: B

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Fundamentals of Corporate Finance 3e

48.

49.

50.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Bond issuance costs include A) investment banking fees. B) legal fees. C) accountant fees. D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Income taxes have the effect of A) increasing the cost of debt for a firm. B) decreasing the cost of debt for a firm. C) decreasing the cost of equity for a firm. D) Both B and C are correct Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Bellamee, Inc. has semiannual bonds outstanding with five years to maturity, and the bonds are priced at $920.87. If the bonds have a coupon rate of 7 percent, then what is the YTM for the bonds? Round your final percentage answer to two decimal places. A) 4.5% B) 7.0% C) 9.0% D) 9.2% Ans: C Feedback: Semiannual coupon payment = $1,000 × 7% ÷ 2 = $35 The semiannual YTM can be calculated as 4.5% by entering the following data in a financial calculator. PMT = 35, PV = –920.87, FV = 1,000, N = 10 Hence, the YTM = 2 × 4.5% = 9%

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Fundamentals of Corporate Finance 3e

51.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Dynamo Corporation has semiannual bonds outstanding with 12 years to maturity, and the bonds are currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the equivalent annual return (EAR) to the investor for purchasing the bonds at the described price? Round your final percentage answer to two decimal places. A) 3.5% B) 7.00% C) 7.12% D) 8.00% Ans: C Feedback: Using the formula for pricing bonds, we have

$1, 080.29 = $40 x PVIFA(YTM / 2, 24) + $1, 000 x PVIF (YTM / 2, 24) and after solving for YTM / 2 = 3.5%, we find that YTM = 7.0%. Note that we assume semi − annual coupons for the bond . 0.07 2 Now, we adjust for EAR : (1 + ) − 1 = 0.0712 = 7.12% 2

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Fundamentals of Corporate Finance 3e

52.

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Beckham Corporation has semiannual bonds outstanding with 13 years to maturity and the bonds are currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 35%? Round your intermediate calculation to two decimal places & final percentage answer to three decimal places. A) 6.250% B) 8.125% C) 12.500% D) 12.890% Ans: B Feedback: Using the formula for pricing bonds, we have

$746.16 = $42.50 x PVIFA(YTM / 2, 26) + $1, 000 x PVIF (YTM / 2, 26) and after solving for YTM / 2 = 6.25%, we find that YTM = 12.50%. Note that we assume semi − annual coupons for the bond . Now, we adjust taxes :12.50% x (1 − 0.35) = 8.125%

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Fundamentals of Corporate Finance 3e

53.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective PackMan Corporation has semiannual bonds outstanding with nine years to maturity and the bonds are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 30 percent? Round your intermediate calculation to two decimal places & final percentage answer to three decimal places. A) 7.050% B) 8.225% C) 11.750% D) 12.095% Ans: A Feedback: Using the formula for pricing bonds, we have

$754.08 = $36.25 x PVIFA(YTM / 2,18) + $1, 000 x PVIF (YTM / 2,18)

and after solving for YTM / 2 = 5.875%, we find that YTM = 11.75%. Note that we assume semi − annual coupons for the bond . Now, we adjust taxes :11.75% x (1 − 0.3) = 8.225%

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Fundamentals of Corporate Finance 3e

54.

55.

56.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective A recent leveraged buyout was financed with $50M. This amount comprised of partner’s equity capital of $12M, $20M unsecured debt borrowed at 7% from one bank, and the remainder from another bank at 8.5%. What is the overall after-tax cost of the debt financing if you expect the firm’s marginal tax rate to be 33%? A) 2.55% B) 3.34% C) 5.17% D) 7.71% Ans: C Feedback: Total debt = $50M – $12 = $38M Weighted average pretax cost of debt = 7% × (20/38) + 8.5% × (18/38) = 7.71% After-tax cost of debt = 7.71% × (1 – 0.33) = 5.17%

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The appropriate risk-free rate to use when calculating the cost of equity for a firm is A) a long-term Treasury rate. B) a short-term Treasury rate. C) an equal mix of short-term and long-term Treasury rates. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The average risk-premium for the market from 1926 to 2012 was A) 8.00%. B) 7.50%. C) 5.71% . D) 6.51% + the Treasury rate. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy .

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Fundamentals of Corporate Finance 3e

57.

58.

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Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The recommended model to estimate the cost of common equity for a firm is A) the one-stage constant growth dividend model. B) the multistage –growth dividend model. C) the capital asset pricing model(CAPM). D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective Jacque Ewing Drilling, Inc. has a beta of 1.3 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the expected return on the market is 12 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 40 percent? A) 7.92% B) 13.20% C) 15.57% D) 23.60% Ans: B Feedback: The equation for CAPM is ∶ 𝐸(𝑅𝑖)= 𝑅𝑟𝑓 + 𝛽𝑖 [𝐸(𝑅𝑚 ) − 𝑅𝑟𝑓 ]. 𝐼𝑓 𝛽𝑖 = 1.3, 𝑅𝑟𝑓 = 0.08, 𝑎𝑛𝑑 𝐸(𝑅𝑚 ) = 0.12, 𝑡ℎ𝑒𝑛 𝑤𝑒 ℎ𝑎𝑣𝑒 𝐸(𝑅𝑖)= 0.08 + 1.3 × [0.12 − 0.08] = 0.132 = 13.20%

59.

11.20% 10.60% 15.14% 16.00% D 13-20

Fundamentals of Corporate Finance 3e

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Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + i  E ( Rm ) − Rrf  . If i = 1.4, Rrf = 0.09, and E ( Rm ) − Rrf = 0.05, then we have E ( Ri ) = 0.09 + 1.4  0.05 = 0.16 = 16.00%

60.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective Radical VenOil, Inc. has a cost of equity capital equal to 22.8 percent. If the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, then what is the firm's beta if the marginal tax rate is 35 percent? A) 1.0 B) 1.28 C) 1.60 D) 4.10 Ans: C Feedback:

The equation for the CAPM is : E ( Ri ) = Rrf + i  E ( Rm ) − Rrf  . If E ( Ri ) = 0.228, Rrf = 0.10, and E ( Rm ) = 0.18, then we have 0.228 = 0.10 + i  0.18 − 0.10 === i = 1.60

61.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Gangland Water Guns, Inc. is expected to pay a dividend of $2.10 one year from today. If the firm's growth in dividends is expected to remain at a flat 3 percent forever, then what is the cost of equity capital for Gangland if the price of its common shares is currently $17.50? A) 12.00% B) 14.65% C) 15.00% D) 15.36% Ans: C Feedback:

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Since the price of common shares is given as well as the expected growth in dividend and the next expected dividend, we can use the following:

kcs =

62.

D1 $2.10 +g = + 0.03 = 0.15 = 15% P0 $17.50

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective UltraFlex Diving Boards, Inc. just paid a dividend of $1.50. If the firm's growth in dividends is expected to remain at a flat 4 percent forever, then what is the cost of equity capital for Ultra Flex Diving Boards if the price of its common shares is currently $26.00? A) 5.77% B) 6.00% C) 9.77% D) 10.00% Ans: D Feedback:

Since the price of common shares is given as well as the exp ected growth in dividends and the last paid dividend , we can use the following : D  (1 + g ) D $1.50 1.04 kcs = 1 + g = 0 +g= + 0.04 = 0.10 = 10% P0 P0 $26.00

63.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Turquoise Electronics, Inc. paid a dividend of $1.87 last year. If the firm's growth in dividends is expected to be 10 percent next year and then zero thereafter, then what is its cost of equity capital if the price of its common shares is currently $25.71? A) 7.27% B) 8.00% C) 18.00% D) The problem is not solvable with the information that is given. Ans: B Feedback: D1 = D0 × (1 + g1) = $1.87 × 1.10 = $2.057 kcs = (D1 / P0) + gc = (2.057 / $25.71) + 0= 8%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The Dedus Shoes, Inc. has common shares with a price of $28.76 per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to grow at 10 percent for two years and then at 5 percent, thereafter. What is the implied cost of common equity capital for Dedus? Round your final percentage answer to 1 decimal place. A) 7.00% B) 8.00% C) 9.00% D) 10.00% Ans: C Feedback:

We can use the common stock pricing equation to solve for the cos t of common equity capital : $1.00(1.1) $1.00(1.1)2 $1.00 (1.1) (1.05) $28.76 = + + ; Trial and error gives us kcs = 0.09 (1 + kcs ) (1 + kcs )2 ( kcs − 0.05)(1 + kcs )2 2

65.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Tranquility, Inc. has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of common equity capital for Tranquility? Round your final percentage answer to 1 decimal place. A) 9.5% B) 10.5% C) 11.5% D) 12.5% Ans: C Feedback: We can use the common stock pricing equation to solve for the cost of common equity capital.

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Fundamentals of Corporate Finance 3e

$18.37 =

Test Bank

$1.50(1.09) $1.50(1.09)2 $1.50(1.09)3 $1.50(1.09)3 (1.02) + + + 2 3 (1+𝑘𝑐𝑠 ) (1+𝑘𝑐𝑠 ) (1+𝑘𝑐𝑠 ) (𝑘𝑐𝑠 −0.02)(1+𝑘𝑐𝑠 )3

By trial and error method, the value of kcs can be found out as 11.5%.

66.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Oasis, Inc. has common shares with a price of $21.12 per share. The firm is expected to pay a dividend of $1.75 one year from today, and dividends are expected to grow at 10 percent for two years after that and then at 5 percent thereafter. What is the implied cost of common equity capital for Oasis? Round your final answer to nearest percentage. A) 13% B) 14% C) 15% D) 16% Ans: B Feedback: We can use the common stock pricing equation to solve for the cost of common equity capital. $1.75 $1.75(1.10) $1.75(1.10)2 $1.75(1.10)2 (1.05) $21.12 = + + + (1 + 𝑘𝑐𝑠 ) (1 + 𝑘𝑐𝑠 )2 (1 + 𝑘𝑐𝑠 )3 (𝑘𝑐𝑠 − 0.05)(1 + 𝑘𝑐𝑠 )3 By trial and error method, the value of kcs can be found out as 14%.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective .

13-24

Fundamentals of Corporate Finance 3e

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Billy's Goat Coats has a preferred share issue outstanding with a current price of $38.89. The firm last paid a dividend on the issue of $3.50 per share. What is the firm's cost of preferred equity? Round your final answer to nearest percentage. A) 7% B) 8% C) 9% D) 10% Ans: C Feedback: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps / Pps = $3.50 / $38.89 = 9%.

68.

69.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Wally's War Duds has a preferred share issue outstanding with a current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year from today. What is the firm's cost of preferred equity? Round your final answer to nearest percentage. A) 6.50% B) 7.00% C) 7.50% D) 8.00% Ans: B Feedback: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps / Pps = $1.86 / $26.57 = 7%.

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firm is expected to pay a dividend of $2.34 per share a year from today. What is the firm's cost of preferred equity? A) 11.50% B) 11.75% C) 12.00% D) 12.25% Ans: C Feedback: We start with the pricing equation for preferred shares and rearrange to solve for the cost of preferred equity. kps = Dps / Pps = $2.34 / $19.50 = 12%.

70.

71.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective In order to use a firm’s WACC to evaluate its future project's flows, which of the following must hold? A) The project will be financed with the same proportion of debt and equity as the firm. B)

The systematic risk of the project is the same as the overall systematic risk of the firm.

C) D) Ans:

The project should have conventional cash flows. Both A and B above D

Format: Multiple Choice Learning Objective: LO3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective If the market risk premium is currently 6 percent and the risk-free rate of return is 4 percent, then what is the expected return on a common share with a beta equal to 2? A) 8.0% B) 10.0% C) 12.0% D) 16.0% Ans: D Feedback: E(Ri) = Rrf + βi [E(Rm) – Rrf] = 0.04 + 2.0 × 0.06 = 0.04 + 0.12 = 0.16=16.0%

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective What is the beta of a firm whose equity has an expected return of 21.3 percent when the risk-free rate of return is 7.0 percent and the expected return on the market is 18.0 percent? A) 0.79 B) 1.30 C) 1.57 D) None of the above Ans: B Feedback: E(Ri) = Rrf + βi [E(Rm) – Rrf] ➔ 0.213 = 0.07 + βi [0.18 – 0.07] ➔ βi= 1.30

73.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Stryder, Inc. has 3 million shares outstanding at a current price of $15 per share. The book value of the shares is $10 per share. The firm also has $30 million in par value of bonds outstanding. The bonds are selling at a price equal to 101 percent of par. What is the market value of the firm? A) $30.0 million B) $45.0 million C) $75.0 million D) $75.3 million Ans: D Feedback: MV of assets = MV of liabilities + MV of equity = (1.01 × $30,000,000) + (3,000,000 × $15) = $75,300,000

74.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective The Diverse Co. has invested 40 percent of the firm's assets in a project with a beta of 0.4 and the remaining assets in a project with a beta of 1.8. What is the beta of the firm? A) 0.96 B) 1.24

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C) 1.28 D) None of the above Ans: B Feedback: 2

 n Asset portfolio =  xi i = 0.4(0.4) + 0.6(1.8) = 1.24 i =1

75.

76.

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective You are analyzing the cost of capital for a firm that is financed with 65 percent equity and 35 percent debt. The cost of debt capital is 8 percent, while the cost of equity capital is 20 percent for the firm. What is the overall cost of capital for the firm? A) 12.2% B) 14.0% C) 15.8% D) 20.0% Ans: C Feedback: kFirm = xDebtkDebt + xEquitykEquity = (0.35 × 0.08) + (0.65 × 0.2) = 0.158=15.8%

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective You are analyzing the cost of capital for a firm that is financed with $300 million of equity and $200 million of debt. The cost of debt capital for the firm is 9 percent, while the cost of equity capital is 19 percent. What is the overall cost of capital for the firm? Assume there are no taxes. A) 13.0% B) 14.0% C) 15.0% D) 16.0% Ans: C Feedback: xDebt = 200 / 500 = 0.4, xEquity = 300 / 500 = 0.6 kFirm = xDebtkDebt + xEquitykEquity = (0.4 × 0.09) + (0.6 × 0.19) = 0.15=15%

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium .

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Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The WACC for a firm is 19.75 percent. You know that the firm is financed with $75 million of equity and $25 million of debt. The cost of debt capital is 7 percent. What is the cost of equity for the firm? Assume there are no taxes. A) 19.75% B) 24.00% C) 32.50% D) 58.00% Ans: B Feedback: xDebt = 25/100 = 0.25, xEquity = 75/100 = 0.75 kFirm = xDebtkDebt + xEquitykEquity, ➔ 0.1975 = (0.25 × 0.07) + (0.75 × kEquity) ➔ kEquity = 0.2400=24%

78.

79.

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective The WACC for a firm is 13.00 percent. You know that the firm's cost of debt capital is 10 percent and the cost of equity capital is 20%. What proportion of the firm is financed with debt? Assume there are no taxes. A) 30% B) 33% C) 50% D) 70% Ans: D Feedback: xDebt = Y, xEquity = (1 – Y) kFirm = xDebtkDebt + xEquitykEquity ==> 0.13= (Y × 0.1) + ((1 – Y) × 0.20) ➔ Y = 0.7=70%

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Swirlpool, Inc. has found that its cost of common equity capital is 18 percent, and its cost of debt capital is 8 percent. The firm is financed with 60 percent common shares and 40 percent debt. What is the after-tax weighted average cost of capital for Swirlpool, if it is subject to a 40 percent marginal tax rate? A)

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B) 12.00% C) 12.72% D) 14.00% Ans: C Feedback:

The formula for WACC is : WACC = xDebt k Debt pretax (1 − t ) + x ps kcs = 0.4  0.08  (1 − 0.4) + 0.6  0.18 = 0.1272 =12.72%

80.

Format: Multiple Choice Learning Objective: LO1 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Maloney's, Inc. has found that its cost of common equity capital is 17 percent and its cost of debt capital is 6 percent. The firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt. What is the after-tax weighted average cost of capital for Maloney's, if it is subject to a 40 percent marginal tax rate? A) 8.96% B) 11.16% C) 11.64% D) 12.60% Ans: C Feedback: Noting that the proportion of debt and equity is 𝑥𝐷𝑒𝑏𝑡 = $2,000,000/($3,000,000 + $2,000,000) = 0.4,𝑥𝐶𝑆 = $3,000,000/($3,000,000 + $2,000,000) = 0.6 The formula for WACC is: WACC = 𝑥𝐷𝑒𝑏𝑡 𝑘𝐷𝑒𝑏𝑡 𝑝𝑟𝑒𝑡𝑎𝑥 (1-t) + 𝑥𝑝𝑠 𝑘𝐶𝑆 = 0.4 × 0.06×(1-0.4) + 0.6×0.17 = 0.1164

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A) 6.05% B) 9.6% C) 8.75% D) 13.65% Ans: B Feedback: The weightage for debt and equity are calculated as follows: 𝑥𝐷𝑒𝑏𝑡 = $750,000,000/($750,000,000 + 250,000,000)=0.75 𝑥𝑐𝑠 = $250,000,000/($750,000,000 + 250,000,000)=0.25 WACC = xDebt kDebt pretax × (1 – t) + xps kcs=0.75 × 0.12 × (1 – 0.35) + 0.25 × 0.15 = 0.096 = 9.6%

82.

Format: Multiple Choice Learning Objective: LO1,2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Poly's Parrot Shops has found that its cost of common equity capital is 17 percent. It has 7year maturity semiannual bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Poly's, if it is subject to a 35 percent marginal tax rate? Round your final percentage answer to two decimal places. A) 10.20% B) 11.76% C) 11.88% D) 13.32% Ans: D Feedback: xDebt = $80,000,000 / ($120,000,000 + $80,000,000) = 0.4 xcs = $120,000,000 / ($120,000,000 + $80,000,000) = 0.6 Coupon payment = $1,000 × 7% / 2 = $35 By entering the following data in a financial calculator, the YTM, which is the cost of debt, of the bond can be calculated as 12%. PMT = 35, PV = –767.03, FV = 1,000, N = 14. WACC = xDebt kDebt pretax × (1 – t) + xps kcs= 0.4 × 0.12 × (1 – 0.35) + 0.6× 0.17 = 0.1332 = 13.32%

Format: Multiple Choice Learning Objective: LO1,3 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective

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Marley's Pipe Shops has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. Its cost of debt financing is 12 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Marley's, if it is subject to a 35 percent marginal tax rate? A) 10.20% B) 11.76% C) 11.88% D) 13.32% Ans: D Feedback:

Noting that the proportion of debt and equity is xDebt = $80, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.4, xcs = $120, 000, 000 /($120, 000, 000 + $80, 000, 000) = 0.6 The return on common shares can be found with the CAPM : The equation for the CAPM is : E ( Ri ) = Rrf + i  E ( Rm ) − Rrf   E ( Ri ) = 0.08 + 1.5   0.14 − 0.08 = 0.17

The formula for WACC is : WACC = xDebt k Debt pretax (1 − t ) + x ps kcs = 0.4  0.12  (1 − 0.35) + 0.6  0.17 = 0.1332 =13.32%

84.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective Droz's Hiking Gear, Inc. has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. It has 7-year semiannual maturity bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Droz's, if it is subject to a 35 percent marginal tax rate? Round your final percentage answer to two decimal places. A) 10.20% B) 11.76% C) 11.88% D) 13.32% Ans: D 13-32

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Feedback:

The price of the bonds can be used to find the YTM : $767.63 = $35  PVIFA (YTM / 2,14 ) + $1, 000  PVIF (YTM / 2,14 )  YTM / 2 = 6%  YTM = 12% = k Debt pretax The formula for WACC is : WACC = xDebt k Debt pretax (1 − t ) + x ps kcs = 0.4  0.12  (1 − 0.35) + 0.6  0.17 = 0.1332

85.

86.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Which type of project do financial managers typically use the highest cost of capital when evaluating? A) Extension projects B) New product projects C) Efficiency projects D) Market expansion projects Ans: B

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Briefly explain why the book value of debt might not reflect the current cost of debt for a firm, with respect to a single issuance of debt? Ans: The book value of debt or bonds will be reflective of the market and firm risks at the 13-33

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time the bonds were issued. If market or firm conditions have changed materially since that time, then the market price of the bonds will reflect the current cost of debt equity for the firm rather than the book value of that debt.

87.

88.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Explain the conditions under which the constant-growth dividend formula for the cost of common stock can be used to find the cost of common equity capital for a firm. Ans: The first condition that must hold is that the growth rate in dividends must be constant for the foreseeable future of a firm. This condition does not generally hold for growing or contracting firms. The second condition is that the growth rate in dividends must be less than the cost of equity capital for the firm.

Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Discuss the two major conditions for when a firm may use its current weighted average cost of capital to evaluate a new project's cash flows. Ans: a) The first condition is that the proportions of capital (debt, common shares, and preferred shares) that a firm is relying on to finance the firm must also be utilized to finance the new project. Any material deviation from that mix will alter the individual cost of each type of financing. b) The second condition is that the level of systematic risk inherent in the overall portfolio of projects a firm is currently taking on must be the same as the level of systematic risk for the new project.

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Chapter 14: Working Capital Management

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 1. The appropriate mix of current assets is not a working capital management decision. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 2. Net working capital is important because it is a measure of a firm’s liquidity and represents the net short-term investment the firm keeps in the business. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 3. Working capital management involves making decisions regarding the use and sources of current assets. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 4. Working capital efficiency refers to the length of time it takes for a firm to convert the raw material to a finished product. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. Liquidity is the ability of a company to convert assets—real or financial—into cash quickly without suffering a financial loss. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 6. The operating cycle begins when the firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 7. The cash conversion cycle is the length of time between the cash outflow for materials and the cash inflow from sales. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 8. Days' payables outstanding (DPO), which tells how long, on average, a firm takes to pay off its suppliers for the cost of inventory, is used to measure the operating cycle. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 9. Day’s payables outstanding (DPO) is computed as number of days in a year divided by accounts payable turnover. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 10. An efficient firm with good working capital management should have a high average collection period compared to that of its industry. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 11. The flexible current asset management strategy calls for management to invest large amounts in cash, short-term investments, and inventory. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 12. The flexible current asset management strategy is perceived to be a high-risk and low-return course of action for management to follow. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 13. The restrictive current asset management strategy is a high-risk, high-return alternative to a flexible strategy. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 14. If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 15. If carrying costs are less than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. Trade credit, which is short-term financing, comes with an explicit interest charge. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 17. An offer of 3/10, net 40 means that the selling firm offers a 10 percent discount if the buyer pays the full amount of the purchase in cash within 3 days of the invoice date. Otherwise, the buyer has 40 days to pay the balance in full from the date of delivery. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Trade credit is a cheap loan from the supplier. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 19. The aging schedule shows the breakdown of the firm's accounts receivable by their date of sale. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 20. The conflict between carrying costs and shortage costs is called the working capital trade-off. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 21. A firm that employs just-in-time management has to increase its investment in working capital. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 22. Float is the time taken by a credit customer to pay the firm. A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Kno wledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 23. A lockbox system allows geographically dispersed customers to send their payments to a post office box close to them. A) True B) False Ans: A

Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 24. Under the maturity matching strategy, a firm funds all seasonal working capital needs with short-term borrowing. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 25. Short term funding strategy calls for all seasonal working capital and a portion of the permanent working capital and fixed assets to be funded with short-term debt. A) True B) False Ans: A

Format: True/False Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 26. An informal line of credit is short term debt promissory notes issued by large financial firms. A) True B) False Ans: B

Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 27. A factor is an individual or financial institution that buys accounts receivable without recourse. A) True B) False Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 28. Which of the following statements is NOT true? A) Gross working capital is the funds invested in a company's current liabilities. B) Net working capital (NWC) refers to the difference between current assets and current liabilities. C) Working capital efficiency refers to the length of time between when a working capital asset is acquired and when it is converted into cash. D) Working capital management involves making decisions regarding the use and sources of current assets. Ans: A

The lower the cash balance, the better the ability of a firm to meet its short-term financial obligations. The level of the cash balance has no bearing on a firm's ability to meet its short-term financial obligations. The downside of holding too much cash is that the returns on cash are low.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 30. Which of the following is the equation for net working capital? A) Total assets – total liabilities B) Current assets – current liabilities C) Current assets / current liabilities D) Total assets / total liabilities Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 31. The cash conversion cycle A) shows how long a firm keeps its inventory before selling it. B) begins when a firm invests cash to purchase the raw materials that would be used to produce the goods that the firm manufactures. C) begins when a firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales. D) estimates how long it takes on average for a firm to collect its outstanding accounts receivable balance. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 32. Which of the following statements is NOT true? A) The cash conversion cycle begins when a firm invests cash to purchase the raw materials that would be used to produce the goods that the firm manufactures. B) The cash conversion cycle begins when the firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales. C) To measure the cash conversion cycle, we need another measure called the days' payables outstanding. D) The cash conversion cycle ends not with the finished goods being sold to customers and the cash collected on the sales; but when you take into account the time taken by a firm to pay for its purchases. Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 33. The operating cycle A) begins when a firm receives the raw materials that would be used to produce the goods that the firm manufactures. B) begins when a firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales. C) cannot be measured without knowing the days' payables outstanding. D) does not end with the finished goods being sold to customers and the cash collected on the sales; but when you take into account the time taken by the firm to pay for its purchases. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 34. Which of the following statements is true when managing working capital accounts? A) Maintain minimal raw material inventories without causing manufacturing delays. B) Use as little labor as possible to manufacture the product while producing a quality product. C) Delay paying accounts payable as long as possible without suffering any penalties. D) All of the above are true. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 35. Which of the following statements is true? A) Cash conversion cycle = DSO + DSI + DPO B) Cash conversion cycle = DSO + DSI − DPO C) Cash conversion cycle = DSO − DPO D) None of the above. Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 36. Which of the following statements is NOT true? A) Cash conversion cycle = DSO + DSI − DPO B) Operating cycle = DSO + DSI C) Both A and B D) None of the above Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 37. Trend Foods distributes its products to more than 100 restaurants and delis. The company's collection period is 32 days, and it keeps its inventory for 10 days. What is Trend's operating cycle? A) 22 days B) 32 days C) 42 days D) None of the above Ans: C Feedback:

Operating cycle = DSO + DSI = 32 + 10 = 42 days

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 38. Stamp, Inc. has an operating cycle of 81 days and takes 47 days to collect on its receivables. What is its level of inventory if the firm's cost of goods sold is $312,455? Round your final answer to the nearest dollar. A) $9,190 B) $14,685 C) $29,105 D) $69,339 Ans: C Feedback: Operating cycle = DSO + DSI DSI = OC – DSO = 81 – 47 = 34 days

Inventory Inventory Inventory = = COGS 365 $312,455 365 $856.04 Inventory = 34  856.04 = $29,105.40

DSI = 34 days =

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 39. Le Baron Company, a men's designer firm, has an operating cycle of 123 days. The firm's days' sales in inventory is 73 days. How much does the firm have in receivables if it has credit sales of $433,450? Round your final answer to the nearest dollar. A) $59,377 B) $71,252 C) $47,501 D) $64,233 Ans: A Feedback: Operating cycle = DSO + DSI DSO = OC – DSI = 123 – 73 = 50 days Credit sales = $433,450

Accounts receivables Accounts receivables = = 50 days Credit sales 365 $433, 450 365 Accounts receivables = 50  $1,187.53 = $59, 376.71

DSO =

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 40. All Stars, Inc. has inventory of $44,233 and cost of goods sold of $512,902. The company has an operating cycle of 74 days. What is the firm's days' sales outstanding (DSO)? Round your answers to the nearest whole number. A) 43 days B) 32 days C) 49 days D) 26 days Ans: A Feedback:

DSI =

Inventory $44,233 = = 31.5 days COGS 365 $512,902 365

Operating cycle = DSO + DSI DSO = Operating cycle – DSI = 74 – 31.5 = 42.5 days OR 43 days

Reference: 14-1: Use the following information to answer questions 41-42: You are provided the following working capital information for the Ridge Company: Ridge Company Account Inventory $12,890 Accounts receivable 12,800 Accounts payable 12,670 Credit sales Cost of goods sold

$124,589 99,630

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-1 41. What is the operating cycle for Ridge Company? Round your final answer to the nearest whole number. A) 47 days B) 85 days C) 36 days D) 51 days Ans: B Feedback:

OR 85 days.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-1 42. What is the cash conversion cycle for Ridge Company? Round your final answers to one decimal place. A) 83.5 days B) 38.3 days C) 129.9 days D) 46.4 days Ans: B Feedback:

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 43. Wolfgang Electricals estimates that the company takes 31 days on average to pay off its suppliers. It also knows that it has days' sales in inventory of 54 days and days sales' outstanding of 34 days. What is its cash conversion cycle? A) 119 days B) 34 days C) 57 days D) 46 days Ans: C Feedback: Cash conversion cycle = DSO + DSI – DPO = 34 + 54 – 31 = 57 days

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 44. Renald Corp. estimates that the company takes 27 days on average to pay off its suppliers. It also knows that it has days' sales in inventory of 43 days and days sales' outstanding of 45 days. What is its cash conversion cycle? A) 61 days B) 115 days C) 57 days D) 46 days Ans: A Feedback: Cash conversion cycle = DSO + DSI – DPO = 45 + 43 – 27 = 61 days

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Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 45. Your boss asks you to compute the company's cash conversion cycle. Looking at the financial statements, you see that the average inventory for the year was $126,300, accounts receivable were $97,900, and accounts payable were at $115,100. You also see that the company had credit sales of $324,000 and that cost of goods sold was $282,000. What is your firm's cash conversion cycle? Round to the nearest day. A) 119 days B) 34 days C) 57 days D) 125 days Ans: D Feedback:

Accounts receivables $97,900 = = 110.3 days Credit sales 365 $324, 000 365 Inventory $126,300 DSI = = = 163.5 days COGS 365 $282, 000 365 Accounts payables $115,100 DPO = = = 149 days COGS 365 $282, 000 365 Cash conversion cycle = DSO + DSI − DPO DSO =

= 110.3 + 163.5 − 149 = 124.8 days OR 125 days

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 46. West Handicrafts, Inc. has net sales of $423,000 with 30 percent of it being credit sales. Its cost of goods sold is $324,000. The firm's cash conversion cycle is 47.9 days. The firm's operating cycle is 86.3 days. What is the firm's accounts payable? Round to the nearest dollar. Do not round your intermediate calculations. A) $34,087 B) $126,900 C) $71,203 D) $56,322 Ans: A Feedback: Net sales = $423,000 Credit sales = (0.3 × $423,000) = $126,900

Cash conversion cycle = ( DSO + DSI ) − DPO 47.9 = 86.3 − DPO DPO = 38.4 days Accounts payables Accounts payables DPO = = = 38.4 days COGS 365 $324, 000 365 Accounts payables = 38.4  $887.67 = $34, 086.53

OR $34,087 Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 47. The flexible current asset investment strategy A) has a high percent of current assets to sales, is generally perceived to be a low-risk and low-return course of action. B) calls for management to invest large amounts in cash, short-term investments, and inventory. C) leads to high levels of accounts receivable. D) All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 48. Which of the following is NOT true about the flexible current asset investment strategy? A) The strategy promotes a liberal trade credit policy for customers. B) The strategy calls for management to invest large amounts in cash, short-term investments, and inventory. C) The strategy is perceived be a high-risk and high-return course of action for management to follow. D) The strategy's downside is the high inventory carrying cost. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 49. A restrictive current asset investment strategy calls for A) levels of current assets kept to a minimum. B) a firm barely investing in cash, marketable securities and inventory. C) tight terms of sale intended to curb credit sales and accounts receivable. D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 50. The restrictive current asset management strategy is a high-risk, high-return alternative to the flexible strategy because of A) financial shortage costs. B) production shortage costs. C) human resources shortage costs. D) None of the above Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 51. Which of the following statements is true? A) Financial shortage costs arise mainly from illiquidity—shortage of cash or a lack of marketable securities to sell for cash. B) Operating shortage costs result from lost production and sales. C) Operating shortage costs can be substantial, especially if the product markets are competitive. D) All of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 52. Operating shortage costs that result from lost production and sales are caused by A) not holding enough raw materials in inventory. B) running out of finished goods. C) restrictive credit policies. D) All of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 53. Which of the following statements about working capital trade-off is true? A) Financial managers need to balance shortage costs against carrying costs to find an optimal management strategy. B) If carrying costs are greater than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. C) If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. D) All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 54. Which of the following statements about working capital trade-off is NOT true? A) Financial managers need to balance shortage costs against carrying costs to find an optimal management strategy. B) If carrying costs are smaller than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. C) If shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. D) Management will try to find the level of current assets that minimizes the sum of the carrying costs and shortage costs. Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 55. The aging schedule A) shows the breakdown of a firm's accounts receivable by their date of sale. B) identifies and then tracks delinquent accounts to see that they are paid. C) is an important financial tool for analyzing the quality of a company's receivables. D) All of the above. Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 56. Which of the following statements is NOT true? A) Accounts payable (trade credit), bank loans, and commercial paper are common sources of short-term financing. B) An informal line of credit is a verbal agreement between the firm and the bank, allowing the firm to borrow up to an agreed-upon limit. C) An informal line of credit is a special type of collateralized loan. D) A formal line of credit is also known as “revolving credit.” Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 57. Senter Corp. sells its goods with terms of 2/10 EOM, net 30. What is the implicit cost of the trade credit? Round your final percentage answer to 2 decimal places. Do not round your intermediate calculations. A) 18.50% B) 30.00% C) 44.59% D) 21.89% Ans: C Feedback: Credit terms = 2/10 EOM, net 30 Effective annual rate = (1 + (Discount / Discounted price)) 365 / days credit – 1 = (1 + 2 / 98)365 / 20 – 1 = (1.0204)18.2500 – 1 = 1.4459 – 1 = 0.4459, or 44.59%

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 58. Kearns, Inc. sells its goods with terms of 3/15 EOM, net 60. What is the implicit cost of the trade credit? Round your final answer to the nearest whole percent. Do not round your intermediate calculations. A) 15% B) 45% C) 34% D) 28% Ans: D Feedback: Credit terms = 3/15 EOM, net 60 Effective annual rate= (1 + (Discount / Discounted price))365 / days credit – 1 = (1 + 3 / 97)365/45 – 1 = (1.0309)8.1111 – 1 = 1.2800 – 1 = 0.28, or 28%

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 59. Which of the following statements is true of economic order quantity (EOQ)? A) The EOQ mathematically determines the minimum total inventory cost. B) The EOQ takes into account inventory reorder costs and inventory carrying costs. C) The optimal order size is determined by the EOQ model. D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 60. Which of the following statements is NOT true of economic order quantity (EOQ)? A) The economic order quantity (EOQ) mathematically determines the minimum total inventory cost. B) The EOQ ignores inventory reorder costs and inventory carrying costs. C) The optimal order size is determined by the EOQ model. D) The EOQ is directly proportional to the sales per period. Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 61. Which of the following statements about just-in-time inventory management policy is NOT true? A) It calls for the exact day-by-day, or even hour-by-hour raw material needs to be delivered by the suppliers. B) If the supplier fails to make the needed deliveries, then production shuts down. C) A big disadvantage in this system is that there are high raw inventory costs. D) It eliminates obsolescence or loss to theft. Ans: C

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Test Bank

Reference 14-2: Use the following to answer questions 62-63: Jensen Autos, one of the largest car dealers in Eau Claire, sells about 700 vehicles a year. The cost of placing an order with their supplier is $1,100, and the inventory carrying costs are $120 for each car. Most of their sales are in late fall of each year.

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-2 62. What is the number of cars per order? Round your final answer to the nearest whole number. A) 80 cars B) 101cars C) 58 cars D) 113 cars Ans: C Feedback:

EOQ = =

2  Reorder costs  Sales per period Carrying cos ts 2  $1,100  700 = 113.3 $120

The number of cars per order = 113 cars.

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective Reference 12-2 63. How many orders will the dealer need to place this year? Round your answer to the whole number. A) 4 orders B) 5 orders C) 6 orders D) 7 orders Ans: C Feedback: Number of orders = 700 / 113 = 6 orders.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 64. Ticktock Clocks sells 10,000 alarm clocks each year. If the total cost of placing an order is $65 and it costs $85 per year to carry the alarm clock in inventory, calculate the optimal order size using the EOQ formula. Round your final answer to nearest whole number. A) 124 clocks B) 161 clocks C) 15,294 clocks D) 26,154 clocks Ans: A Feedback:

EOQ = =

2  Reorder costs  Sales per period Carryingcos ts 2  $65  10,000 = 123.7 $85

The optimal order size = 124 clocks.

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 65. Which of the following statements about collection time is NOT true? A) Collection time, or float, is the time between when a customer makes a payment and when the cash becomes available to the firm. B) Collection time can be broken down into three components. C) Delivery time or mailing time is not part of the collection time. D) Processing delay is one of the components of the collection time. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 66. Porter Corp. has just signed up for a lockbox. Management expects the lockbox to reduce the mail float by 2.3 days. The firm's sales on average are $41,250 a day, with the average check being $165. The bank charges $0.39 per processed check. Assume that there are 270 business days in a year and the opportunity cost of funds is 5 percent. What will the firm's savings be from using the lockbox? A) $3,427.50 B) $975.50 C) $2,632.50 D) $94,875.00 Ans: A Feedback: Average daily sales = $41,250 No. of business days = 270 Average check amount = $165 No. of checks processed per day = $41,250 / $165 = 250 Collection time saved = 2.3 days Per check processing fee = $0.39 Opportunity cost of funds = 0.05 The cost of a lockbox = 250 checks × $0.39 per check × 270 days = $26,325 Savings from mail float = 2.3 days × $41,250 = $94,875 Savings from lockbox = ($94,875 – $26,325) × 0.05 = $68,550 × 0.05 = $3,427.50

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 67. Rocky Corp. has daily sales of $18,100. The financial manager determined that a lockbox would reduce the collection time by 2.2 days. Assuming the company can earn 6 percent interest per year, what are the savings from the lockbox? Round your final answer to the nearest dollar. A) $3,621 B) $2,389 C) $39,820 D) $1,100 Ans: B Feedback: Average daily sales = $18,100 Collection time saved = 2.2 days Savings from mail float = 2.2 days × $18,100 = $39,820 Savings from the lockbox = $39,820 × 0.06 = $2,389

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 68. Which of the following statements about maturity matching strategy is true? A) All seasonal working capital needs are funded with short-term borrowing. B) As the level of sales varies seasonally, short-term borrowing fluctuates with the level of seasonal working capital. C) All fixed assets are funded with long-term financing. D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 69. Which of the following statements about short-term funding strategy is true? A) All seasonal working capital needs and a portion of permanent working capital and fixed assets are funded with short-term debt. B) The downside to this strategy is that a portion of a firm’s long-term assets must be periodically refinanced over their working lives. C) It can take advantage of an upward-sloping yield curve and lower a firm’s overall cost of funding. D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 70. Which of the following statements is NOT true? A) Firms using maturity matching strategy fund all working capital needs with long-term borrowing. B) Long-term financing strategy relies on long-term debt to finance both capital assets and working capital. C) All permanent working capital and fixed assets are funded with long-term debt when firms use a maturity matching strategy. D) Firms using a maturity matching strategy fund all seasonal working capital needs with short-term borrowing. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. Serengeti Travels has borrowed $50,000 at a stated APR of 8.5 percent. The loan calls for a compensating balance of 8 percent. What is the effective interest rate for this company? Round your final percentage answer to two decimal places. A) 9.24% B) 8.50% C) 8.00% D) 16.50% Ans: A Feedback: Amount to be borrowed = $50,000 Stated annual interest rate = 8.5% Compensating balance = 8% Amount deposited as compensating balance = $50,000 × 0.08 = $4,000 Effective borrowing amount = $50,000 – $4,000 = $46,000 Interest expense = $50,000 × 0.085 = $4,250 Effective interest rate = Interest expense / Effective borrowing amount = $4,250 / $46,000 = 9.24%

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Sun Prairie Traders borrowed $63,000 at an APR of 10 percent. The loan called for a compensating balance of 10 percent. What is the effective interest rate on the loan? Round your final percentage answer to two decimal places. A) 10.00% B) 11.11% C) 8.00% D) 12.50% Ans: B Feedback: Amount to be borrowed = $63,000 Stated annual interest rate = 10% Compensating balance = 10% Amount deposited as compensating balance = $63,000 × 0.10 = $6,300 Effective borrowing amount = $63,000 – $6,300 = $56,700 Interest expense = $63,000 × 0.10 = $6,300 Effective interest rate = $6,300 ÷ $56,700 = 11.11%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 73. Good Homes Furnishings is borrowing $225,000. The loan requires a 10 percent compensating balance, and the effective interest rate on loan is 8.25 percent. What is the stated APR on this loan? Round your final percentage answer to two decimal places. Do not round your intermediate calculations. A) 10.00% B) 11.11% C) 7.43% D) 8.25% Ans: C Feedback: Amount to be borrowed = $225,000 Effective interest rate = 8.25% Compensating balance = (0.10 × $225,000) = $22,500 Effective borrowed amount = $225,000 – $22,500 = $202,500 Interest expense = Effective interest rate × Effective borrowing amount = 0.0825 × $205,500 = $16706.25. Stated interest rate = $16,706.25 / $225,000 = 7.43%

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. Maggie's Bistro is borrowing $375,000. The loan requires an 8 percent compensating balance, and the effective interest rate on the loan is 10.326 percent. What is the stated APR on this loan? Round your final percentage answer to 1 decimal place. Do not round your intermediate calculations. A) 10.0% B) 9.5% C) 7.4% D) 8.5% Ans: B Feedback: Amount to be borrowed = $375,000 Compensating balance = (0.08 × $375,000) = $30,000 Effective interest rate = 10.326% Effective borrowed amount = $375,000 – $30,000 = $345,000 Interest expense = Effective interest rate × Effective borrowing amount = 0.10326 × $345,000 = $35,625. Stated interest rate = $35,625 / $375,000 = 9.5%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. Gibbs, Inc. has just set up a formal line of credit of $1 million with First National Bank. The line of credit is good for up to five years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $600,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to 2 decimal places. A) 8.00% B) 7.25% C) 6.58% D) 8.25% Ans: C Feedback: Line of credit limit = $1,000,000 Loan rate = 6.25% Annual fee on unused balance = 0.5% Amount borrowed = $600,000 Unused balance = $400,000 Annual fee = $400,000 × 0.005 = $2,000 Interest expense = $600,000 × 0.0625 = $37,500 Effective interest rate = (Interest expense + Annual fee) / Borrowed amount = ($37,500 + $2,000) / $600,000 = 6.58%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. Trend, Inc. has just set up a formal line of credit of $5 million with First National Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 7.5 percent on the loan, and in addition, the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $2,300,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to one decimal place. A) 8.5% B) 7.2% C) 9.0% D) 8.1% Ans: D Feedback: Line of credit limit = $5,000,000 Loan rate = 7.5% Annual fee on unused balance = 0.5% Amount borrowed = $2,300,000 Unused balance = $2,700,000 Annual fee = $2,700,000 × 0.005 = $13,500 Interest expense = $2,300,000 × 0.075 = $172,500 Effective interest rate = (Interest expense + Annual fee) / Borrowed amount = ($172,500 + $13,500) / $2,300,000 = 8.09% OR 8.1%

77.

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Storm Electronics has set up a formal line of credit of $2 million with First Kentucky Bank. The line of credit is good for up to three years. The bank will be charging them an interest rate of 6.25 percent on the loan, and in addition the firm will pay an annual fee of 60 basis points on the unused balance. The firm borrowed $1,500,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to two decimal places. A) 7.50% B) 6.45% C) 6.25% D) 7.15% Ans: B Feedback: Line of credit limit = $2,000,000 Loan rate = 6.25% Annual fee on unused balance = 0.6% Amount borrowed = $1,500,000

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Fundamentals of Corporate Finance 3e

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Unused balance = $500,000 Annual fee = $500,000 × 0.006 = $3,000 Interest expense = $1,500,000 × 0.0625 = $93,750 Effective interest rate = (Interest expense + Annual fee) / Borrowed amount = ($93,750 + $3,000) / $1,500,000 = 6.45%.

78.

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Pride, Inc. sells $150,000 of its accounts receivable to factors at 2.875 percent discount. The firm's average collection period is 75 days. What is the simple annual interest cost of the factors loan? Round your percentage answer to one decimal place. A) 35.5% B) 32.9% C) 27.8% D) 31.1% Ans: A Feedback: Accounts receivables sold = $150,000 Factor discount = 2.875% Simple monthly interest cost of factoring = 2.875 / (100 –2.875) = 2.875 / 97.125 = 0.0296 Simple annual interest cost of factors loan = 0.0296 × 12 = 35.5%.

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. A firm sells $125,000 of its accounts receivable to factors at 3 percent discount. The firm's average collection period is one month. What is the dollar cost of the factoring service? A) $3,000 B) $4,500 C) $3,750 D) $4,250 Ans: C Feedback: Accounts receivables sold = $125,000 Factor discount = 3% Average collection period = 30 days Dollar cost of factoring per month = $125,000 × 0.03 = $3,750

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 80. Which of the following is a short-term financing instrument? A) Accounts payable B) Bank loans with a maturity of less than 1 year C) Commercial paper D) All of the above Ans: D

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 81. What are some strategies that financial managers can follow in managing their working capital accounts? Ans: When managing working capital accounts, financial managers need to do the following: Delay paying accounts payable as long as possible without suffering any penalties. Maintain minimal raw material inventories without causing manufacturing delays. Use as little labor as possible to manufacture the product while producing a quality product. Maintain minimal finished goods inventories without losing sales. Offer customers the most attractive credit terms possible on trade credit to maximize sales while minimizing the risk of nonpayment. Collect cash payments on accounts receivable as fast as possible to close the loop.

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Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 82. Explain working capital trade-off. Ans: The optimal current asset management strategy of a firm will depend on the relative magnitudes of carrying costs versus shortage costs. This conflict is often referred to as the working capital trade-off. Financial managers need to balance shortage costs against carrying costs to find out an optimal strategy. If carrying costs are larger than shortage costs, then the firm will maximize value by adopting a more restrictive strategy. On the other hand, if shortage costs dominate carrying costs, the firm will need to move toward a more flexible policy. Overall, management will try to find the level of current assets that minimizes the sum of the carrying costs and shortage costs.

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Strategic Planning AICPA: Industry/Sector Perspective 83. How does a just-in-time inventory management work? Ans: In a just-in-time system, the exact day-by-day or even hour-by-hour raw material needs are delivered by the suppliers, who deliver the goods “just in time” for them to be used on the production line. A big advantage in this system is that there are essentially no raw material inventory costs and no chance of obsolescence or loss to theft. On the other hand, if the supplier fails to make the needed deliveries, then production shuts down. If the system works for a firm, it cuts down their investment in working capital dramatically.

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Chapter 15 How Firms Raise Capital Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. Most businesses are started when an entrepreneur who has a vision is given seed funding by institutional investors. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2. The process by which many entrepreneurs raise seed money and obtain other resources necessary to start their businesses is often called bootstrapping. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. The initial seed money usually comes from the entrepreneur or other founders. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. The bootstrapping period usually lasts for at least five years. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. Venture capitalists are individuals or firms that help privately held businesses by providing funds in the bootstrapping process. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. Angel investors are investors who come to the rescue of firms threatened by takeovers. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. A significant number of venture capital firms focus on high-technology investments. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8. A significant number of venture capital firms focus on mature businesses. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. Traditional sources of funding, such as from financial and insurance firms, work for new or emerging businesses despite the presence of only intangible assets. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm's financial performance. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11. A principal way for venture capitalists to exit is to sell part of the firm's equity back to the entrepreneur. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12. A venture capitalist may exit an investment by selling common stock in an initial public offering. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. The amount of equity capital that can be raised in the public equity markets is typically smaller than the amount that can be raised through private sources. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 14. Privately held firms find it easier to attract top management talent and to better motivate current managers. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15. To complete an IPO, a firm will need the services of investment bankers, who are experts in bringing new securities to market. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. To complete an IPO, a firm will need the services of angel investors, who are experts in bringing new securities to market. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. Underwriting is the risk-bearing part of investment banking. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. In the firm-commitment underwriting, which is more typical, the investment banker guarantees the issuer a fixed amount of money from the stock sale. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 19. With a firm-commitment underwriting, the investment banking firm makes no guarantee to sell the securities at a particular price. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20. In a best-effort offering, the underwriter promises to make its “best effort” to sell all securities at a certain price. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 21. Underpricing is defined as offering new securities for sale at a price below their true value. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 22. In a firm-commitment offering, the underwriters will suffer a financial loss if the offer price is set too high. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 23. If the offer price is set too high, the issuing firm will lose under a best-effort agreement. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24. A general cash offer is a sale of debt or equity, open to all investors, by a registered public company that has previously sold stock to the public. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 25. Bootstrapping and venture capital financing are part of the public market operations of a business. A) True B) False Ans: B

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 26. Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 27. The biggest drawback of private placements involves restrictions on the resale of the securities. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. Transactions, in which a public company sells unregistered stock to an investor, such as a hedge fund or some other institutional investor, are called PIPE transactions. A) True B) False Ans: A

Format: True/False Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 29. The major disadvantage of a PIPE transaction to issuers is that the funding cost is higher as compared to making a public offer. A) True B) False Ans: B

Format: True/False Learning Objective: LO 7 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 30. Term loans are defined as business loans with maturities greater than one month but less than one year. A) True B) False Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 31. The initial seed money usually comes from A) public investors. B) investment banks. C) the entrepreneur or other founders. D) commercial banks. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 32. Bootstrapping is the process by which A) many entrepreneurs raise seed money and obtain other resources necessary to start their businesses. B) the entrepreneur often fleshes out his or her ideas and makes them operational. C) most businesses are started by an entrepreneur. D) None of the above Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 33. Which of the following statements is NOT true? A) The process by which many entrepreneurs raise seed money and obtain other resources necessary to start their businesses is often called bootstrapping. B) Most businesses are started by an entrepreneur who has a vision for a new business or product and a passionate belief in the concept's viability. C) The initial “seed” money usually comes from the entrepreneur or other founders. D) The seed money is spent on developing an initial public offering. Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34. Which of the following statements is true? A) The venture capital industry as we know it today emerged in the late 1960s with the formation of the first venture capital limited partnerships. B) Modern venture capital firms tend to specialize in a specific line of business, such as hospitality, food manufacturing, or medical devices. C) A significant number of venture capital firms focus on high-technology investments. D) All of the above statements are true. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35. Which of the following statements is NOT true? A) Venture capitalists bear a substantial amount of risk when they fund a new business. B) Venture capitalists’ sole function is to provide financing for new firms. C) Modern venture capital firms tend to specialize in a specific line of business, such as hospitality, food manufacturing, or medical devices. D) A significant number of venture capital firms focus on high-technology investments. Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36. Tactics that venture capitalists use to reduce the risk of their investment include A) funding the ventures in stages, requiring entrepreneurs to take charge of all important business decisions . B) funding the ventures completely in the beginning, requiring entrepreneurs to make personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize. C) funding the ventures in stages, requiring entrepreneurs to make personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize. D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 37. Which of the following statements is NOT true? A) Venture capitalists often require an entrepreneur to make a substantial personal investment in the business. B) Syndication occurs when the originating venture capitalist buys off other venture capitalists involved in the venture. C) Another factor that reduces risk is the venture capitalist's in-depth knowledge of the industry and technology. D) The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm's financial performance. Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. Provisions that are part of venture capital agreements include A) timing of exit, number of board positions after exit, and what price is acceptable. B) timing of exit, the method of exit, and what price is acceptable. C) the method of exit, number of board positions after exit, and what price is acceptable. D) None of the above Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39. The three principal ways in which venture capital firms exit venture-backed companies are A) selling to a strategic buyer, buying out the founder, and offering stock to the public. B) selling to a strategic buyer, selling to a financial buyer, and buying out the founder. C) selling to a strategic buyer, selling to a financial buyer, and offering stock to the public. D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. A typical venture capital fund may generate annual returns of A) 15 to 25 percent on the money that it invests, compared with an average annual return for the S&P 500 of almost 12 percent. B) 12 percent on the money that it invests, compared with an average annual return for the S&P 500 of about 20 percent. C) 12 percent on the money that it invests, compared with an average annual return for the S&P 500 of about 25 percent. D) None of the above Ans: A

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41. Advantages of going public include all EXCEPT A) larger amount of capital can be raised this way than the amount that can be raised through private sources. B) the cost of going public is less compare to debt financing. C) going public can enable an entrepreneur to fund a growing business without giving up control. D) additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. Which of the following statements is true? A) After the IPO, there is a less active secondary market for the firm's shares. B) Only smaller amounts of capital can be raised through an IPO than the amount that can be raised through private sources. C) Publicly traded firms find it easier to attract top management talent. D) Going public can enable an entrepreneur to fund a growing business but not without giving up control. Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 43. Disadvantages of going public include all EXCEPT A) managers' tendency to focus on long-term profits. B) the high cost of the IPO itself. C) the costs of complying with ongoing SEC disclosure requirements. D) the transparency that results from this compliance can be costly for some firms. Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. All of the following about a firm-commitment underwriting is true EXCEPT A) the investment banker guarantees the issuer a fixed amount of money from the stock sale. B) the investment banker actually buys the stock from the firm. C) the issuer bears the risk that the resale price might be lower than the price the underwriter pays. D) the underwriter bears the risk that the resale price might be lower than the price the underwriter pays. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. With a best-effort underwriting A) the investment banking firm makes no guarantee to sell the securities at a particular price. B) the investment banker does not bear the price risk associated with underwriting the issue. C) the compensation is based on the number of shares sold. D) All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. Which of the following statements is NOT true? A) In a best-effort offering, the underwriters will suffer a financial loss if the offer price is set too high. B) In a best-effort agreement, the issuing firm will lose if the offer price is set too high. C) If the underpricing is significant, the investment banking firm will suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client than it could have. D) Underpricing is defined as offering new securities for sale at a price below their true value. Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. Basic services investment bankers provide when bringing securities to market include A) origination. B) underwriting. C) distribution. D) All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. Which of the following statements is NOT true? A) Investment bankers provide three basic services when bringing securities to market— origination, underwriting, and distribution. B) During the origination phase, the investment banker helps the firm determine whether it is ready for an IPO. C) Origination is the risk-bearing part of investment banking. D) Origination includes giving the firm financial advice and getting the issue ready to sell. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. The three basic costs associated with issuing stock in an IPO are A) price premium, out-of-pocket expenses, and underpricing. B) underwriting spread, out-of-pocket expenses, and underpricing. C) underwriting spread, price premium, and underpricing. D) None of the above Ans: B

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. Data from the marketplace show that the shares sold in an IPO are typically A) priced between 2 and 5 percent below the price at which they close at the end of the first day of trading. B) priced between 10 and 15 percent above the price at which they close at the end of the first day of trading. C) priced between 10 and 15 percent below the price at which they close at the end of the first day of trading. D) priced between 2 and 5 percent above the price at which they close at the end of the first day of trading. Ans: C

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. Stump, Inc. a technology firm in Prairie View, Texas, issues a $66 million IPO priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $350,000. The firm's stock price increases 15 percent on the first day. What is the underpricing spread? A) $51 million B) $15 million C) $66 million D) None of the above Ans: B Feedback: Underwriter's gross spread ($22 − $17) = $5 per share. Number of shares sold = ($66 million ÷ $22 per share) = 3 million. Underwriting cost = ($5 per share × 3.0 million shares) = $15.0 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. Stump, Inc. a technology firm in Prairie View, Texas, issues a $66 million IPO priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $350,000. The firm's stock price increases 15 percent on the first day. What is the underpricing on this issue? A) $9,900,000 B) $24,900,000 C) $15,000,000 D) None of the above Ans: A Feedback: Stock price at end of the first day = $22(1.15) = $25.30 First-day underpricing = ($25.30 − $22) = $3.30 per share. Total underpricing = ($3.30 per share × 3,000,000 shares of stock) = $9,900,000

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. Stump, Inc. a technology firm in Prairie View, Texas, issues a $66 million IPO priced at $17 per share, and the offering price to the public is $22 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $350,000. The firm's stock price increases 15 percent on the first day. What is the firm's total cost of issuing the securities? A) $24.9 million B) $15.35 million C) $25.25 million D) None of the above Ans: C Feedback: Total cost to the firm of selling the IPO = $15,000,000 + $350,000 + $9,900,000 = $25,250,000

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. Pau, Inc. issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the underpricing cost of issuing the securities to the firm? (Round your intermediate calculations to two decimal places.) A) $13.60 million B) $20.60 million C) $6.94 million D) $7.57 million Ans: C Feedback: Stock price at end of the first day = $19.30 × (1.18) = $22.77 First-day underpricing = ($22.77 – $19.30) = $3.47 per share. Number of shares outstanding = ($38.6 million ÷ $19.3 per share) = 2 million. Total underpricing = ($3.47 per share × 2,000,000 shares of stock) = $6,940,000

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 55. Pau, Inc. issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the underwriting cost? A) $13.6 million B) $20.6 million C) $6.94 million D) None of the above Ans: A Feedback: Underwriter's gross spread ($19.30 – $12.50) =$6.80 per share. Number of shares outstanding = ($38.6 million ÷ $19.30 per share) = 2 million. Underwriting cost = ($6.80 per share × 2.0 million shares) = $13.6 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 56. Pau, Inc. issues a $38.6 million IPO priced at $12.50 per share, and the offering price to the public is $19.30 per share. The firm's legal fees, SEC registration fees, and other administrative costs are $270,000. The firm's stock price increases 18 percent on the first day. What is the total cost of issuing the securities to the firm? A) $13,606,000 B) $20,818,000 C) $20,610,000 D) None of the above Ans: B Feedback: Stock price at end of the first day = $19.30 (1.18) = $22.774 First-day underpricing = ($22.774 − $19.30) = $3.474 per share. Total underpricing = ($3.474 per share × 2,000,000 shares of stock) = $6,948,000 Underwriter's gross spread ($19.30 − $12.50) = $6.80 per share. Number of shares outstanding = ($38.6 million ÷ $19.30 per share) = 2 million. Underwriting cost = ($6.80 per share × 2.0 million shares) = $13.6 million Total cost to the firm of selling the IPO = $13,600,000 + $270,000 + $6,948,000 = $20,818,000

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 57. When Geo Corp. went public in September 2008, the offer price was $19.00 per share and the closing price at the end of the first day was $24.70. The firm issued 4 million shares. What was the loss to the company due to underpricing? A) $13.6 million B) $20.83 million C) $20.6 million D) $22.8 million Ans: D Feedback: Change in price on the first day = $24.70 − $19.00 = $5.70 Number of shares outstanding = 4.0 million Loss due to underpricing = $5.70 × 4,000,000 = $22.8 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 58. Bethesda Biosys issues an IPO on a best-effort basis. The company's investment bank demands a spread of 18 percent of the selling price. The average selling price remains at $25 per share. Four million shares are issued. What are the net proceeds for the issuer? A) $82 million B) $92 million C) $100 million D) None of the above Ans: A Feedback: Underwriting spread = $25 × 0.18 = $4.5 Proceeds to issuer = ($25 – $4.5) × 4 million = $82 million

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 59. Fortune Hotels issues an IPO on a best-effort basis. The company's investment bank demands a spread of 20 percent of the selling price. Five million shares are issued. The average selling price remains at $31. What are the net proceeds per share for the issuer? A) $27.50 B) $22 C) $31 D) $24.8 Ans: D Feedback: Number of shares issued = 5 million Underwriting spread = 20% × $31 = $6.2 Proceeds to issuer = ($31 – $6.2) = $24.8 per share

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 60. Fortune Hotels issues an IPO on a best-effort basis. The company's investment bank demands a spread of 20 percent of the selling price. Five million shares are issued. The average selling price remains at $31. How much did the investment bank receive? A) $22.0 million B) $27.5 million C) $31.0 million D) None of the above Ans: C Feedback: Underwriting spread = 20% × $31 per share × 5 million shares = $31 million Proceeds to underwriter = $31 million

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 61. Dienz Pharma plans to issue an IPO on a best-effort basis. The company's investment bank demands a spread of 16 percent of the selling price. The selling price is $32 per share. Three million shares are issued. What are the proceeds for the issuer? A) $96.00 million B) $78.75 million C) $80.64 million D) None of the above Ans: C Feedback: Number of shares issued = 3 million Underwriting spread = $32 × 0.16 = $5.12 Proceeds to issuer = ($32 – $5.12) × 3 million shares = $80.64 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. The most likely reason that underpricing of new issues occurs more frequently than overpricing is the: A) Underwriters’ desire to reduce the risk of a firm commitment. B) Demand for a new issue is typically too high. C) Underwriters earn low rates of return. D) Issuing firms demand that equity be underpriced. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. A firm is making an initial public offering. The investment bankers agree to a firm underwriting commitment of 500,000 shares priced to the public at $50 a share. The underwriter’s spread is 12%. In addition, the underwriter charges $600,000 in legal fees. On the first day of trading, the firm’s stock closed at $61. What were the total costs of the issue? A) $3,000,000 B) $3,600,000 C) $8,500,000 D) $9,100,000 Ans: D Feedback: Stock price at end of the first day = $61.00 First-day underpricing = ($61.00 – $50.00) = $11.00 per share. Total underpricing = ($11.00 per share × 500,000 shares of stock) = $5,500,000 Underwriter's gross spread ($50.00 × .12) =$6.00 per share. Underwriting cost = ($6.00 per share × 500,000 shares) = $3 million Total cost to the firm of selling the IPO = $3,000,000 + $600,000 + $5,500,000 = $9,100,000

Format: Multiple Choice Learning Objective: LO 5

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Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. Which of the following statements is NOT true? A) In a competitive sale, the firm specifies the type and amount of securities it wants to sell. B) In a negotiated sale, the issuer selects the underwriter at the beginning of the origination process. C) In a general cash offer, management must decide whether to sell the securities on a competitive or a negotiated basis. D) For equity securities, competitive sales generally provide the lowest-cost method of sale. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 65. Which of the following statements is NOT true of shelf registration? A) Shelf registration gives firms less flexibility in bringing securities to market. B) During a two-year window, the firm can take the securities “off the shelf” and sell them as needed. C) Shelf registration allows firms to periodically sell small amounts of securities. D) A shelf registration statement can cover multiple securities, and there is no penalty if authorized securities are not issued. Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 66. Benefits from shelf registration include all EXCEPT A) greater flexibility in bringing securities to market. B) shelf registration allows firms to periodically sell small amounts of securities and raise capital as needed. C) a shelf registration statement can cover multiple securities, but there is a penalty if authorized securities are not issued. D) costs associated with selling the securities are reduced because only a single registration statement is required. Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. Star Corporation, an auto fuel cell maker, is planning a new plant and needs to raise $30 million to finance it. The company plans to raise the money through a general cash offering priced at $23.50 a share. Star's underwriters charge a 6 percent spread. How many shares does the company have to sell to achieve its goal? (Round your final answer to the nearest unit of share.) A) 1,358,081 shares B) 1,276,596 shares C) 1,200,000 shares D) None of the above Ans: A Feedback: Underwriter's spread = 6% Price per share the firm gets = 23.50 × (1 − 0.06) = $22.09 Therefore, to raise $30 million, the company needs to issue: $30,000,000 ÷ $22.09 = 1,358,081 new shares

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. Why is the total cost of bringing a general cash offer to the market lower than issuing an IPO? A) General cash offer does not include a large underpricing B) Underwriting spreads are smaller in case of general cash offer C) There is less risk involved with a general cash offer than an IPO D) All of the above Ans: D

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. Which of the following statements is NOT true? A) For many smaller firms and firms of lower credit standing that have limited access, or no access, to the public markets, the cheapest source of external funding is often the private markets. B) Bootstrapping and venture capital financing are not part of the private market. C) The biggest drawback of private placements involves restrictions on the resale of the securities. D) Many private companies that are owned by entrepreneurs, families, or family foundations and are sizable companies of high credit quality prefer to sell their securities in the private markets. Ans: B

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 70. Which of the following statements is NOT true? A) Private placement occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals. B) In private placements, there are no restrictions on the resale of the securities. C) About half of all corporate debt is sold through the private placement market. D) Investment banks and money center banks often assist firms with private placements. Ans: B

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. Advantages of private placements include A) lower cost of funds. B) more willingness among private lenders to negotiate changes to a bond contract. C) the speed of private placement deals and flexibility in issue size. D) All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Which of the following statements is NOT true? A) Private equity firms pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments. B) Private equity firms invest in more mature companies. C) Agency problems tend to be more in firms owned by private equity investors than in public firms. D) Private equity investors focus on firms that have stable cash flows because they use a lot of debt to finance their acquisitions. Ans: C

Format: Multiple Choice Learning Objective: LO 6 Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective Level of Difficulty: Medium 73. Private equity firms improve the performance of firms in which they invest by: A) making sure that the firms have the best possible management teams. B) closely monitoring each firm's performance and providing advice and counsel to the firm's management team. C) facilitating mergers and acquisitions that help improve the competitive positions of the companies in which they invest. D) All of the above Ans: D

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Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. Which of the following statements is NOT true of PIPE transactions? A) PIPE transactions are registered with the SEC. B) PIPE transaction gives issuers faster access to capital. C) In a PIPE transaction, investors purchase securities (equity or debt) directly from a publicly traded company in a private placement. D) The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets. Ans: A

Format: Multiple Choice Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. Which of the following statements is true of PIPE transactions? A) Under federal securities law, they can be resold to investors in the public markets immediately even if they are not registered. B) As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing. C) As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC after 90 days of the PIPE closing. D) PIPE transactions involving a healthy firm can also be executed without the use of an investment bank but result in a cost increase of 7 to 8 percent of the proceeds. Ans: B

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. Jasper, Inc. is looking for a five-year term loan of $3 million. Its bank is willing to make the loan. The firm will have to pay a premium of 1.5 percent for default risk and another 0.75 percent for maturity risk. The current prime rate is 7.5 percent. What is the loan rate on this bank loan? A) 9% B) 8.25% C) 9.75% D) None of the above Ans: C Feedback: Prime rate = PR = 7.5% Maturity risk premium = MAT = 0.75% Default risk premium = DRP = 1.5% The loan rate = k = PR + DRP + MAT = 7.5% + 1.5% + 0.75% = 9.75%

Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 77. Suppose two firms want to borrow money from a bank for a period of 10 years. Firm A has excellent credit and can borrow at the prime rate, whereas Firm B's credit standing is prime rate plus 2 percent. The current prime rate is 5.75 percent, the 30-year Treasury bond yield is 4.35 percent, the three-month Treasury bill yield is 3.54 percent, and the 10-year Treasury note yield is 4.24 percent. What are the appropriate loan rates for both the firms? A) 6.45% for Firm A, 7.75% for Firm B B) 6.45% for Firm A, 8.45% for Firm B C) 5.75% for Firm A, 8.45% for Firm B D) None of the above Ans: B Feedback: Prime rate =PR = 5.75%; Maturity risk premium = MAT = y10-year − yT-bill = 4.24% − 3.54% = 0.70% Borrowing rate for Firm A = kA = Prime rate + MAT = 5.75% + 0.70% = 6.45% Borrowing rate for Firm B = kB = Prime rate + 2% + MAT = 5.75% + 2% + 0.70% = 8.45%

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 78. Marigold Corp. wants to borrow money from Howard Bank for a period of five years. The firm's credit standing calls for a premium of 1.5 percent over the prime rate. The current prime rate is 6.5 percent, the 30-year Treasury bond yield is 5.375 percent, the three-month Treasury bill yield is 3.525 percent, and the 5-year Treasury note yield is 4.25 percent. What is the appropriate loan rate for this customer? A) 8.725% B) 7.225% C) 6.500% D) None of the above Ans: A Feedback: Prime rate =PR = 6.5%; Default risk premium = DRP = 1.5% Maturity risk premium = MAT = y5-year − yT-bill = 4.25% − 3.25% = 0.725% Borrowing rate for firm A = ki = PR +DRP+ MAT = 6.5% + 1.5% + 0.725% = 8.725%

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Format: Multiple Choice Learning Objective: LO 7 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. Castle Co. needs to borrow $10 million for process improvement upgrades. Management decides to sell 20-year bonds. They determine that the 3-month Treasury bill rate is 2.75 percent, the firm's credit rating is A, and the yield on 20-year Treasury bonds is 1.80 percent higher than that for 3-month Treasury bills. Bonds with an A rating are selling for 50 basis points above the 20-year Treasury bond rate. What is the borrowing cost for this transaction? A) 4.55% B) 5.05% C) 7.75% D) 9.55% Ans: B Feedback: ki = 2.75 + 1.80 + 0.50 = 5.05%

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 80. Why do traditional sources of funding not work for new or emerging businesses? Ans: New firms cannot resort to traditional sources of funding for three main reasons. First, starting a new business is a risky proposition. The fact is that most new businesses fail, and it is difficult to identify which firms will be successful. Most suppliers of capital, such as banks, pension funds, and insurance companies, are averse to undertaking highrisk investments, and much of their risk-averse behavior is mandated in regulations that restrict their conduct. Second, most commercial loans are made to firms that have tangible assets, such as machines, equipment, and physical inventory. Lenders understand the operations of these “traditional” firms and their inherent risks; thus, they are comfortable making loans to them. New firms whose primary assets are often intangibles, such as patents or trade secrets, find it difficult to secure financing from traditional lending sources. The third reason is the information gap that exists between the entrepreneur and potential investors. An entrepreneur knows more about his or her company's prospects than a lender does. When dealing with highly specialized technologies or companies emerging in new business areas, most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs. As a result, they are reluctant to invest in these firms. For these reasons, many investors—such as pension funds, insurance companies,

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endowment funds, and university foundations—find it difficult to participate directly in the venture capital market. Instead, they invest in venture capital funds that specialize in identifying attractive investments in new businesses, managing those investments, and selling (exiting) them at the appropriate time.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 81. What are the advantages and disadvantages of going public? Ans: Going public has a number of potential advantages. · The amount of equity capital that can be raised in the public equity markets is typically larger than the amount that can be raised through private sources. · Once an IPO has been completed, additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost. · Going public can enable an entrepreneur to fund a growing business without giving up control. · After the IPO, there is an active secondary market in which stockholders can buy and sell its shares. · Publicly traded firms find it easier to attract top management talent and to better motivate current managers if a firm's stock is publicly traded. There are also several disadvantages of going public. · One disadvantage of going public is the high cost of the IPO itself. · The costs of complying with ongoing SEC disclosure requirements also represent a disadvantage of going public. · The transparency that results from this compliance can be costly for some firms. · Finally, some investors argue that the SEC's requirement of quarterly earnings forecasts and quarterly financial statements encourages managers to focus on short-term profits rather than long-term wealth maximization.

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Format: Essay Learning Objective: LO 6 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 82. What are PIPE transactions and how do they help firms raise capital? Ans: Private investment in public equity (PIPE) transactions are transactions in which a public company sells unregistered stock to an investor. In a PIPE transaction, investors purchase securities (equity or debt) directly from a publicly traded company in a private placement. The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets to compensate the buyer for limits on the liquidity associated with these securities and, often, for being able to provide capital quickly. Because the securities sold in a PIPE transaction are not registered with the SEC, they are “restricted securities.” As part of the PIPE contract, the company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing. If the registration is delayed past a deadline date, the issuer might be required to pay the investor liquidity damages, usually 1 or 1.5 percent per month, as compensation for the loss of liquidity. The major advantages of a PIPE transaction to issuers are that it gives them faster access to capital and a lower funding cost than a registered public offering. PIPE transactions involving a healthy firm can also be executed without the use of an investment bank, resulting in a cost saving of 7 to 8 percent of the proceeds. A PIPE transaction can be the only way for a small financially distressed company to raise equity capital.

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Chapter: 16 Capital Structure Policy Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. A higher fraction of debt indicates a lower degree of financial leverage. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2. Minimizing the cost of a firm's financing activities also maximizes the overall value of the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. When calculating free cash flow, it is important to include interest and principal payments. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not affect real investment policy. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. The enterprise value of a firm is the value of equity minus the value of debt. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. A financial restructuring can change the value of a firm's real assets, such as plant and equipment. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. M&M Proposition 2 states that the required rate of return on a firm's common stock is directly related to the debt-to-equity ratio. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8. M&M Proposition 1 states that the capital structure of a firm does not affect the required rate of return on a firm's assets, while M&M Proposition 2 shows that the required rate of return on firm's equity does change with capital structure decisions. A) True B) False Ans: A

Format: True/False Learning Objective: LO2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. Under the M&M assumptions with taxes, the value of a firm with debt is the value of the firm without debt plus the present value of the interest tax shield. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. With no debt, the WACC is the cost of equity plus the required rate of return on the firm's underlying assets. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11. If a firm has debt and pays taxes, the present value of the tax shield is the amount of debt outstanding times the tax rate. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 14. Direct-bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15. When a firm gets closer to financial distress causing expected bankruptcy costs to increase, lenders will often charge the firm a lower interest rate in order to reduce the chance of an actual bankruptcy occurring. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. Direct bankruptcy costs are considered small when compared to indirect costs. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Unlike direct bankruptcy costs, indirect costs are not considered transaction costs. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 19. Indirect bankruptcy costs will often increase when a firm is in financial stress and it may even push the company into bankruptcy. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20. More debt in a firm’s capital structure provides managers with an incentive to maximize cash flows, but also makes them want to take on negative NPV projects. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 21. Dividends reduce the value of lender claims, and this is why bondholders often limit a firm's ability to distribute cash to equity holders. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 22. Borrowing money and paying out a special dividend to shareholders is an example of the asset substitution problem. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 23. When a firm is in financial distress, stockholders would like to overinvest in positive NPV projects. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24. Without debt in the capital structure, there are no asset substitution or underinvestment problems. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2,3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 25. The trade-off theory of capital structure states that leverage is increased until the marginal cost of debt is equal to the marginal benefit. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 26. Under the pecking order theory, debt is factually the cheapest source of funds due to the interest tax shield. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 30. Managers often focus on cash flows, but reported accounting earnings are a better indicator of a firm's economic health. A) True B) False Ans: B

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Format: True/False Learning Objective: LO Appendix Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 31. An operating lease is treated like a purchase for accounting purposes. A) True B) False Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 32. A firm's capital structure is the mix of financial securities used to finance its activities and can include all of the following except, A) common stock. B) bonds. C) equity options. D) preferred stock. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 33. The optimal capital structure of a firm A) minimizes the cost of financing the firm's projects. B) minimizes interest payments to creditors. C) maximizes overall value of the firm. D) Both A and C. Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34. M&M Proposition 1 assumes all of the following except that, A) there are no taxes. B) there are no costs to acquire information. C) there are no transactions costs. D) the real investment policy of a firm is affected by its capital structure decisions. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35. A firm's enterprise value is given as: A) the value of equity plus the value of debt. B) the value of equity minus the value of debt. C) the value of equity minus the value of debt plus the value of future projects. D) None of the above. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36. A financial restructuring A) will not change the value of a firm's real assets under M&M Proposition 1. B) includes financial transactions that change the capital structure of the firm. C) means that a firm has issued equity to retire debt. D) Both A and B. Ans: D

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 37. The weighted average cost of capital (WACC) includes A) the required return on equity and required return on underlying firm assets. B) the cost of any long term debt and the cost of equity. C) the cost of any long term debt and required return on underlying firm assets. D) None of the above. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. M&M Proposition 2 states that the cost of a firm's common stock is directly related to A) the debt-to-equity ratio. B) the required rate of return on the firm's underlying assets. C) the return of the market index. D) Both A and B. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39. According to M&M Proposition 2, the cost of a firm's equity A) increases with the increase of debt-to-equity ratio. B) decreases with the decrease of debt-to-equity ratio. C) increases with the increase of cost of debt. D) decreases with increase of required rate of return on the firm's underlying assets. Ans: A

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. Financial risk A) refers to the effect that a firm's financing decisions have on the riskiness of the cash flows that the stockholders will receive. B) increases a firm's business risk. C) decreases a firm's business risk. D) is related to how debt affects the business decisions of a firm. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41. Which of the following is a reason financial policy might matter? A) Firms must pay corporate income taxes. B) Capital structure choices can affect firm’s real investment decisions, such as R&D and PP&E. C) Information or transaction costs. D) All of the above Ans: D

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much is Dynamo worth today? A) $1,765 B) $1,500 C) $2,143 D) None of the above Ans: B Feedback:

Firm

CF $150 = = $1,500 i 0.1

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 43. Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much are your cash flows today?(Round the answer to two decimal places.) A) $12.38 B) $15 C) $4.50 D) $150 Ans: A Feedback:

Firm

CF $150 = = $1,500 i 0.1

Cash flows to stockholders = Cash flows – Interest payments = $150 − ($1,500) × (0.25) × (0.07) = $123.75 Therefore, your 10% share = $123.75 × 0.1 = $12.375 OR $12.38

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity and use the debt proceeds to pay a special dividend to stockholders, how much debt should they issue? A) $321 B) $375 C) $600 D) $225 Ans: D Feedback:

Firm

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 − $375 = $225

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much does Dynamo currently pay as interest, and how much will it have to pay after the restructuring in the prior problem, assuming that the cost of debt is constant? A) $42 and $26.25 B) $26.25 and $42 C) $160 and $37.50 D) $37.50 and $60 Ans: B Feedback:

Firm

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1500 = $375 Interest payment on debt before restructuring = $375 × 0.07 = $26.25 Total debt after restructuring = 0.4 × $1,500 = $600 Interest payment on debt after restructuring = 0.07 × $600 = $42

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, how much of the special dividend do you receive, and how much do you receive in regular dividends per annum after the restructuring as per the M&M Proposition 1? A) $15 and $60 B) $60 and $15 C) $10.80 and $22.50 D) $22.50 and $10.80 Ans: D Feedback:

Firm

CF $150 = = $1,500 i 0.1

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, what transaction do you need to take in order to undo the restructuring according to M&M Proposition 1? A) Sell $22.50 of stock B) Sell $10.80 worth of stock C) Buy $22.50 worth of debt D) Buy $10.80 worth of debt Ans: C Feedback:

Firm

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 – $375 = $225 Portion of special dividend received = 0.10 × $225 = $22.50 M&M Proposition 1 says to take your portion of the special dividend ($22.50) and buy that much of the new debt issuance.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, according to M&M Proposition 1, what are the interest payments that you receive after you undo the restructuring, and what are your total cash flows?(Do not round intermediate calculation. Round the final answer to two decimal places.) A) $1.58 and $12.38 B) $23.55 and $75 C) $1.125 and $12.38 D) None of the above Ans: A Feedback:

Firm

CF $150 = = $1,500 i 0.1

Debt today = 0.25 × $1,500 = $375 Debt after restructuring = 0.40 × $1,500 = $600 Total debt issuance = $600 – $375 = $225 Portion of special dividend received = 0.10 × $225 = $22.50 Interest payment on debt after restructuring = 0.07 × $600 = $42 Cash flows to you after restructuring = 0.10 × ($150 – $42) = $10.80 Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 = $1.575 in interest payments. Since you will receive $10.80 in dividends after the restructuring, your total cash flows are $1.575 + $10.80 = $12.38, the same as before the restructuring.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. Cadmium Electronics Inc. currently has a capital structure that is 40% debt and 60% equity. If the firm's cost of equity is 12%, the cost of debt is 8%, and the risk-free rate is 3%, what is the appropriate WACC? A) 8.4% B) 9.6% C) 10.4% D) 9.2% Ans: C Feedback: WACC = xDebt kDebt + xEquity kEquity = (0.40 × 0.08) + (0.60 × 0.12) = 0.104 OR 10.4%

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. Gangland Water Guns, Inc. has a debt-to-equity ratio of 0.5. If the firm's cost of debt is 7% and its cost of equity is 13%, what is the appropriate WACC? A) 9% B) 10% C) 11% D) None of the above. Ans: C Feedback: Using the debt-to-equity ratio, you can solve for the percentage of the capital structure that is debt and the percentage that is equity. If D/E = 0.5, then let's assume that D = 1 and E = 2. Therefore, D + E = 3. This gives a debt percentage of 33.33% and an equity percentage of 66.66%. Then, WACC = xDebt kDebt + xEquity kEquity = (1/3) × 0.07 + (2 / 3) × 0.13 = 0.11 OR 11%.

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. Swirlpool, Inc. has a WACC of 11%, cost of debt of 8%, and a cost of equity of 12%. What must the debt-to-equity ratio be? A) 1/2 B) 1/4 C) 1/6 D) 1/3 Ans: D Feedback: WACC = xDebt kDebt + xEquity kEquity = xDebt × 0.08 + xEquity × 0.12 = 11% Also, D + E = 1 by definition. Therefore, substituting gives you: xDebt × 0.08 + (1 – xDebt) × 0.12 = 0.11. Solving for xDebt gives you 1/4, which means that xEquity must be 3/4. Therefore, the D/E is 1/3.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. Melba's Toast has a capital structure with 30% debt and 70% equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm's marginal corporate income tax rate is 35%. What is the appropriate WACC? A) 8.17% B) 6.35% C) 8.80% D) 7.44% Ans: A Feedback: WACC with taxes = xDebt kDebt pretax (1 − t) + xEquity kEquity = (0.30 × 0.06 × (1 − 0.35)) + (0.70 × 0.10) = 0.0817 OR 8.17%.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. A firm has $300 million in outstanding debt and $900 million in outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the appropriate WACC? A) 6% B) 8% C) 9% D) 10% Ans: D Feedback: WACC = xDebt kDebt + xEquity kEquity = (300 / 1200) × 0.07 + (900 / 1200) × 0.11 = 0.10 OR 10%.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost of equity of 12%, and a marginal corporate income tax rate is of 35%. What percent of the firm’s capital structure is financed with equity? A) 50% B) 60% C) 70% D) None of the above. Ans: B Feedback: WACC = 0.085 = (1 − xEquity)kDebt (1 − t) + xEquity kEquity 0.085 = (1 − xEquity) × 0.05 × (1 − 0.35) + (xEquity × 0.12) Solving for xEquity gives you 0.60 OR 60%.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 55. Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is the required rate of return on its equity? A) 12.15% B) 13.15% C) 14.15% D) None of the above. Ans: B Feedback: kcs = kAssets + (D/E) (kAssets − kDebt) = 0.12 + (1/5) × (0.12 − 0.0625) = 0.1315 OR 13.15%.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 56. Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on its debt to 7%? A) 14% B) 14.25% C) 14.50% D) 15% Ans: A Feedback: kcs = kAssets + (D/E) (kAssets − kDebt) = 0.12 + (2 / 5) (0.12 − 0.07) = 0.14 OR 14%.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 57. Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. What percent of the firm's costs are fixed, and what percent of costs are variable with the added debt? (Round the percentage answer to two decimal places.) A) 27.9% and 72.1% B) 72.1% and 27.9% C) 25.23 and 74.77% D) 74.77% and 25.23% Ans: C Feedback: With the debt, fixed cost percentage is: (SG&A + Interest payments) / (SG&A + Interest payments + COGS) = ($100 + ($700) (0.05)) / ($100 + ($700) (0.05) + $400) = 25.23%. Therefore, variable cost percentage is: $400 / ($100 + ($700) (0.05) + $400) = 0.747664 OR 74.77%.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 59. Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. Suppose, revenues fall by $300, what is the percent change in net income with and without the debt? Assume that the total variable production costs remain the same.(Round the answer to one decimal places.) A) 64.5% and 60% B) 60.0% and 64.5% C) 59.2% and 40.8% D) 40.8% and 59.2% Ans: B Feedback: Without debt, net income = $1000 – $400 – $100 = $500 With debt, net income = $1000 – $400 – $100 – ($700 × 5%) = $465 Without debt, the new net income = $700 − $400 − $100 = $200 Therefore, the percentage change = ($500 − $200) / $500 = 60% With debt, the new net income = $700 − $400 − $100 − $35 = $165 Therefore, the percentage change = ($465 − $165) / $465 = 64.5%

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 60. Suppose a firm has a cost of equity of 12%, a D/E ratioof 1/6, and the YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current required rate of return on its assets and equity if the D/E is changed to 1/3?(Round the answer to one decimal place of percentage.) A) 11.35% and 13.25% B) 11.35% and 8.25% C) 13.25% and 11.35% D) None of the above Ans: D Feedback: kcs = kAssets + (D/E)(kAssets − kDebt) ➔ 12% = kAssets + (1/6) ( kAssets − 7.5%) ➔ kAssets = 11.4% Note that, if D/E ratio changes, kAssets does not change. The new cost of equity is then given as: kcs = 11.4% + (1/3)(11.4% − 7.5%) = 12.6%

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 61. Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders. Using the perpetuity model, calculate the value of the firm without debt in the capital structure. Assume that the pretax annual cash flows are perpetual. Round to the nearest dollar. A) $350 B) $650 C) $2,917 D) $5,417 Ans: D Feedback: VFirm = [ CF × (1 − t)] / i = [$1,000 × (1 − 0.35) ] / 0.12 = $5,417

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders What is Millennium's value after the debt issuance? Assume that the pretax annual cash flows are perpetual. A) $5,417 B) $5,942 C) $6,392 D) None of the above Ans: B Feedback: VFirm = [ CF × (1 – t)] / i = [ $1,000 × (1 – 0.35) ] / 0.12 = $5,417 PV of tax shield = $1,500 × 0.35 = $525 VFirm = V Unleveraged+ PV of the tax shield = $5,417 + $525 = $5,942

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. The interest tax shield A) does not affect the WACC. B) makes it less costly to distribute cash to the investors through interest payments than through dividends. C) is given as: D × (1 − t). D) Both B and C Ans: B

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. In order to calculate the present value of debt tax savings, the _____ is used as the discount rate. A) WACC B) risk-free rate C) required rate of return on debt D) None of the above Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 65. Academic studies have estimated that the tax benefit of debt realized by firms is approximately A) 10% of firm value. B) a 10% reduction in WACC. C) a 10% reduction in the cost of debt. D) 10% of debt value. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 66. The use of debt financing A) causes a manager to take on riskier projects in order to make interest payments. B) is more expensive than issuing equity due to the use of covenants. C) allows managers to make discretionary interest payments. D) limits the ability of managers to waste stockholders’ money. Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. Which of these statements about direct bankruptcy costs is NOT true? A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and consultants. B) Direct bankruptcy costs are less than indirect bankruptcy costs. C) Direct bankruptcy costs include payments to suppliers on delivery. D) Direct bankruptcy costs can be reduced by negotiating with lenders. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. Which of these is NOT an example of indirect bankruptcy costs? A) A firm's customers become concerned about whether or not warranties will be honored. B) Employees begin to leave the firm. C) New accountants are brought in to help with the bankruptcy process. D) A bankruptcy judge orders new projects to be halted. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. The use of debt financing A) reduces agency costs between the stockholders and management by increasing the amount of risk the managers take. B) increases agency costs between the stockholders and management by limiting the amount of risk the managers take. C) increases agency costs since managers prefer to keep more retained earnings rather than paying dividend. D) Both B And C Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 70. The asset substitution problem occurs when A) managers substitute more risky assets for less risky ones to the detriment of bondholders. B) managers substitute less risky assets for more risky ones to the detriment of bondholders. C) managers substitute more risky assets for less risky ones to the detriment of equity holders. D) managers substitute less risky assets for riskier ones to the detriment of equity holders. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. The underinvestment problem occurs in a financially distressed firm when A) the value of investing in a positive NPV project is likely to go to debt holders instead of equity holders. B) the value of investing in a positive NPV project is likely to go to equity holders instead of debt holders. C) management invests in negative NPV projects to reduce their own risk. D) issuing equity becomes difficult due to increased risk. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. The firm borrows $2,000, and its coupon rate is 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings? A) $238 B) $272 C) $259 D) None of the above Ans: A Feedback: After-tax earnings = (Earnings − Interest payments)×(1 − t) Interest payment = $2,000 × 8% = $160 = ($500 − $160) × (1 − 0.3) = $238

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 73. A firm plans to issue $1 million worth of debt at an YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the firm's annual tax liability? A) $13,500 B) $22,500 C) $32,500 D) None of the above Ans: B Feedback: Tax shield = D × kDebt × t = $1,000,000 × 0.09 × 0.25 = $22,500

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. A firm plans to issue $1 million worth of debt at an YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the present value of the tax savings in perpetuity? A) $11,025 B) $20,475 C) $350,000 D) $227,500 Ans: C Feedback: VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM shareholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What will the equity value of UBM be in one-year without stockholders taking on the project? A) $100 million B) $80 million C) $20 million D) $8 million Ans: C Feedback: Value of Equity of UBM = Value of risk-free debt owner − Value of bonds maturing = $100 million – $80 million = $20 million

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the bonds to the lenders if the stockholders sell the debt? A) $100 million B) $88.8 million C) $48.8 million D) None of the above Ans: C Feedback: E[VBonds] = (0.60 × $80 million) + (0.40 × $2 million) = $48.8 million

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 77. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the equity if the stockholders sell the debt? A) $175 million B) $97.5 million C) $51 million D) $40 million Ans: D Feedback: E[VEquity] = ((0.60 × $200 million) − $80 million) + (0.40 × $0 million) = $40 million

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 78. Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in oneyear. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. Given the payoffs of the project, what does the percent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project? A) 1/3 B) 1/4 C) 1/5 D) 1/6 Ans: D Feedback: E[VEquity] = (PSuccess ×( $200 million – $80 million)) + ((1 − PSuccess) × $0) = $20 million (PSuccess × ($200 million − $80 million)) = $20 million Therefore, PSuccess must be 1 / 6.

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. Suppose that, JMK, Inc. has debt with a face value of $100 million and assets worth $70 million. The firm’s management has just identified a project that will require an initial outlay of $10 million and will return a NPV of $16 million, risk-free. The firm currently has no cash. What would be the net return to stockholders if they took on this project? A) −$10 million B) $0 million C) $26 million D) $70 million Ans: A Feedback: If it takes on the project, the firm will receive its $10 million back, along with the $16 million. This gives the firm assets worth $96 million, which is still less than the value of outstanding debt. Therefore, the shareholders would be out the $10 million of equity that the firm had to sell in order to take on the project.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 80. Which of the following supports the trade-off theory of capital structure? A) Firms use cash on hand first, since issuing equity and debt is expensive. B) A firm's capital structure is the result of past equity and debt issuance decisions. C) Firms have a target capital structure. D) Both A and B Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 81. A firm wishes to undertake a project that costs $150 million. It currently has $10 million in cash on hand and believes that it can raise $75 million in debt and $100 million in equity if needed. According to the pecking order theory of the capital structure, what percent of the project will be financed by debt? A) 0% B) 26.67% C) 50% D) None of the above Ans: C Feedback: According to the pecking order theory, the firm will first use its available cash, which is $10 million. Next, the firm will turn to debt. Since the amount of debt it can raise plus the amount of cash on hand is less than the project cost, their entire line of credit will be used. Therefore, $75 million / $150 million = 0.5 OR 50%.

Format: Multiple Choice Learning Objective: LO Appendix Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 82. Which of the following should a company consider when deciding to buy or lease an asset? A) Taxes. B) Information or transaction costs. C) If the choice would affect the real investment policy of the firm. D) All of the above. Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO Appendix Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 83. Which of the following would arise if the lessee can have the incentive to use the asset more than the lessor would prefer? A) Operating lease conflict B) Capital lease conflict C) Intensity of use conflict D) Maintenance conflict Ans: C

Format: Multiple Choice Learning Objective: LO Appendix Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 84. Which of the following arises when the lessee can have the incentive to use the asset more than the lessor would prefer? A) Track the total services obtained from the asset and charge the lessee based on usage. B) Bundle the lease contract with a service contract. C) Provide the lessee with the right to buy the asset when the lease expires. D) All of the above. Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO Appendix Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 85. LMNO Manufacturing needs a new laser and is comparing buying or leasing. Under either alternative, the company will only need the laser for 5 years. Assume LMNO’s marginal tax rate is 30 percent. Purchase Alternative: It would cost $50,000 to purchase the laser and the amount could be financed with a five year balloon loan at 9%. The laser will be depreciated on straight line and have no salvage value. Maintenance on the laser is expected to be $1,200 per year. Lease alternative: The company that manufactures the laser offers a 5 year leasing option with annual lease payments of $12,500.With this option, the lessor will be responsible for maintenance of the laser and will take it back after 5 years. The lease will be classified as an operating lease. Which is the best option for LMNO Manufacturing?(Do not round the intermediate calculation. Round off final answer to the nearest dollar.) A) Purchase, the company will be $4,416 better off B) Lease, the company will be $4,416 better off C) Purchase, the company is $10,496 better off D) Lease, the company is $10,496 better off Ans: B Feedback: Purchase: After-tax annual interest expense = $50,000 × 0.09 × (1 – 0.3) = $3,150 Annual depreciation = $50,000 / 5 = $10,000, so annual tax savings = $10,000 × 0.3 = $3,000 After-tax annual maintenance cost = $1,200 × (1 – 0.3) = $840 So after tax cash flow years 1–4 = ($3,150) + $3,000 + ($840) = ($990) After-tax cash flow year 5 = ($50,000) loan repayment + ($990)= ($50,990) After-tax cost of debt = 0.09(1 – 0.3) = 0.063 NPV of after-tax cash flows = (-$990 / 1.063) + (-$990 / 1.0632) + (-$990 / 1.0633) + (-$990 / 1.0634) + (-$50,990 / 1.0635) = $($40,975.07) Lease: After-tax annual lease payment = $12,500 × (1 – 0.3) = $8,750 Interest rate pre-tax = 9% After-tax interest rate= 9% × (1 – 30%) = 6.3% NPV of ($8,750) for 5 years at 6.3% = $36,559.31 So, the total benefit from leasing is $40,975.08 – $36,559.31 =$4,415.77 OR $4,416.00(rounded)

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 86. One of the conditions that the M&M Propositions required was for not to have taxes. Briefly discuss whether the introduction of taxes decreases or increases the value of the firm. Ans: The relaxation of the no-tax assumptions actually increases the value of a firm by an amount equal to the present value of the tax shield on the firm's debt obligations. If we consider the debt to be infinitely outstanding, then we can approximate the present value of the tax shield by multiplying the amount of the debt by the tax rate.

Format: Essay Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 87. Briefly explain how an increase in the amount of debt that a firm has outstanding may actually decrease the agency costs caused by the conflict between managers and stockholders. Ans: The manager-stockholder agency conflict is caused by a misalignment of interests between the two parties. When a firm has excess cash available for managers to waste— which is bad for stockholders—then an increase in debt, and consequently the level of interest service required of that debt, will make less cash available for the manager to waste. This has the effect of reducing manager-stockholder agency cost.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 88. The pecking order theory of capital structure suggests that managers will choose to utilize retained earnings before issuing additional debt when financing new projects. Does that imply anything about the flotation costs of issuing new securities? Ans: The answer to the question is no. It implies that managers perceive there to be a higher cost of issuing new debt versus stockholder's equity. It is a perception because even after considering flotation costs, new debt is still much cheaper than retained earnings, which belongs to stockholders.

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Fundamentals of Corporate Finance 3e

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Chapter 17: Dividends, Stock Repurchases, and Payout Policy Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. When a firm distributes dividends to stockholders, the amount of equity capital invested in the firm is reduced. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2. A liquidating dividend is a dividend that is paid to stockholders when a firm is liquidated. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. Under U.S. bankruptcy rules, the proceeds from the sale of a company’s assets are first used to pay liquidating dividend to the shareholders before any other party has a claim on those assets. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. Consider an investor who purchases a dividend-paying stock of a public company the day prior to the dividend record date. We would expect this investor to receive a dividend distribution. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. Distributions to the stockholders in the form of a standing discount for products or services that a firm produces are often not thought of as dividends. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. Stock prices react to dividend announcements because the amount of the dividend sends a signal to investors about management's view of the company's prospects. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. Dividends reduce the stockholder's investment in a firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8. Stock prices drop on the ex-dividend date, but usually the drop is less than the amount of the dividend. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. If there are no taxes on dividends, then the price of a stock will not drop on the ex-dividend date. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. Private companies often don't announce dividend payments because private company shares are not frequently traded, and the list of shareholders is relatively small. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11. The record date should never come before the ex-dividend date. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12. Stockholders who don't choose to sell back their shares in a stock repurchase are losing money because the company is only distributing value to the participating shareholders. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. A Dutch auction tender offer stock repurchases always take place at a price higher than the market price of the stock. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 14. Targeted share repurchases always occur at a price higher than the current market quoted price for a stock. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15. Open-market stock repurchases are a convenient way for a company to distribute large amounts cash. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. In a realistic situation, a firm’s dividend policy does not affect the firm value. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. A large regular dividend always denotes a firm with a low level of cash that also has many new project alternatives. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Dividend policy can help a firm maintain a desired capital structure. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 19. Stock repurchases are a stronger indication of free cash flow than dividends. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 20. Compared to raising regular cash dividends, initiating an open-market stock repurchase is generally not as strong a positive signal to the investors because the repurchase can easily be canceled or scaled back before it is completed. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 21. In a world with no taxes, no information or transaction costs, a fixed real investment policy, a dividend policy should not affect the value of a firm. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 23. Suppose that the government raises short and long-term capital gains taxes while leaving all other taxes unchanged. This tax rate change would encourage companies to increase the use of stock repurchases rather than issuing dividends. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy

Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24. Dividend reinvestment programs allow investors to reinvest the dividends they receive into a company's stock without paying taxes on the dividends, or a transaction fee on the stock purchase. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 25. Some companies have been known for paying dividends to current stockholders while simultaneously raising capital through a new equity issue. Generally, this behavior is explained by the need to discipline managers by regularly exposing the company to the extra scrutiny involved in an equity issue. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 26. It is unethical for a corporate board to conduct a large tender offer for stock repurchase when the board members have private information indicating that the company's share price is too low. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 27. Paying a stock dividend does not involve the distribution of any value to the company's stockholders. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 28. Although stock splits do not add any value to a firm, investors tend to react positively to stock splits because management isn't likely to initiate a stock split if the firm's prospects are poor. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 29. A key distinction between stock dividends and stock split is that stock dividends are typically regularly scheduled events, whereas stock splits tend to occur infrequently during the life of a company. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 30. Surveys conducted of managers tell us that they primarily see regular cash dividends as a way to precisely adjust the leverage ratio to the target suggested by the trade-off theory of capital structure. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 31. Which of the following types of dividend is most likely to be used to distribute the revenue from a one-time sale of a large asset? A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 32. Which of the following types of dividend is used to distribute any remaining value when a company's assets are being sold as the company is terminated? A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level Of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 33. Consider a company that had unexpected higher earnings last quarter, and it intends to pay out some additional value to shareholders. Which of the following types of dividend is the company likely to use? A) Regular cash dividend B) Extra dividend C) Special dividend D) Liquidating dividend Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 34. Which of the following steps in the dividend payment process for a public company usually results in a change in the company's stock price? A) Public announcement B) Ex-dividend date C) Payable date D) Both Public announcement and Ex-dividend date Ans: D

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 35. The shares of Milton, Inc. fell sharply today after the company announced that it is increasing its regular cash dividend distributions. Which of the following explanations may explain investors' negative reaction? A) Changes in regular cash dividends are made frequently so that the company's management can adjust for changes in short-term earnings. B) Investors previously believed the company had many lucrative growth opportunities. By announcing higher regular cash dividends, the company is sending a signal that it doesn't have enough positive NPV projects to use all the money. C) Investors expected that the company would announce a stock repurchase rather than a cash dividend increase. Since a change in dividend policy is commonly viewed as a weaker signal than a stock repurchase. The share price fell on the news of the dividend increase. D) None of these Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36. Which of these examples does NOT meet the strict definition for a dividend? A) Steel Gen Corp regularly distributes $0.05 to each shareholder for every share they own. B) Chalone Vineyards once offered their investors discounts on wine in proportion to the number of shares they owned. C) Churchill Downs, Inc. which operates several horse racing tracks, including the location for the Kentucky Derby, distributes two free general admission tickets to every investor who holds more than 100 shares in the company (as of 2012). D) Both Chalone Vineyards once offered their investors discounts on wine in proportion to the number of shares they owned and Churchill Downs, Inc. which operates several horse racing tracks, including the location for the Kentucky Derby, distributes two free general admission tickets to every investor who holds more than 100 shares in the company (as of 2012) Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 37. Jupiter, Co. will be distributing $40 million to shareholders through a special dividend. The company has 160 million shares outstanding. If you own 100 shares of Jupiter, Co. how much will you receive? Ignore taxes. A) $400 B) $100 C) $25 D) None of these Ans: C Feedback: The dividend payment will be ($40 million / 160 million shares) = $0.25 per share. With 100 shares you will receive 100 × $0.25 = $25.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. Mercury, Co. has announced it will pay its regular cash dividend of $0.45 per share. If dividends are taxed, about how much do you expect the price of Mercury, to drop on the exdividend day? The tax rate on dividends is 15 percent. (Round your final answer to two decimal places.) A) $0.07 B) $0.38 C) $0.45 D) $0.52 Ans: B Feedback: The price would be expected to drop by the amount investors receive after taxes $0.45 × 85% = $0.38

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39. You own 10,000 shares of Mars, Co. which is currently trading for $11.50 per share. The company has announced that it will soon pay a special dividend of $1.50 per share. Tomorrow is the ex-dividend day. Ignoring taxes, what do you expect your block of shares will be worth tomorrow? A) $15,000 B) $100,000 C) $115,000 D) $200,000 Ans: B Feedback: With no taxes you expect that the company's stock will drop by $1.50 to $10.00. Your holdings will be worth 10,000 × $10 = $100,000

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. Doorstep, Co. stock is currently trading at $25.70 per share. The company pays a regular cash dividend of $0.40 every quarter. Tomorrow is ex-dividend day for the upcoming regular dividend. Assuming there is no new information released about the company, how much do you expect the company's stock to trade for tomorrow? Assume there are no taxes involved. A) $0.40 B) $25.24 C) $25.30 D) $25.36 Ans: C Feedback: The new stock price would be $25.70 − $0.40 = $25.30

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41. Daniel, Co. stock is currently trading at $38.15 per share. The company pays a regular cash dividend of $0.80 every quarter. Tomorrow is ex-dividend day for the upcoming regular dividend. Assuming there is no new information released about the company. How much do you expect the company's stock to trade for tomorrow? Assume there are no taxes involved. A) $37.47 B) $37.35 C) $37.32 D) $37.23 Ans: B Feedback: The new stock price would be $38.15 − $0.80 = $37.35

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. Ferrico, Co. is currently trading at $37.00 per share. The company is paying a regular cash dividend of $0.40 per share and an extra dividend of $0.10 per share. Tomorrow is the exdividend day. The tax rate on dividends is 15 percent. Assuming there is no new information released about the company. How much do you expect the company's stock to trade for tomorrow? (Do not round the intermediate calculation. Round your final answer to two decimal places.) A) $36.43 B) $36.50 C) $36.58 D) $37.00 Ans: C Feedback: The price would be expected to drop by the amount investors receive after taxes ($0.40 + 0.10) × 85% = $0.425 The new stock price would be $37.00 − $0.425 = $36.58

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 43. Moon, Co. is currently trading at $22.00 per share. The company is paying a regular cash dividend of $0.30 per share, and an extra dividend of $0.05 per share. Tomorrow is the exdividend day. The tax rate on dividends is 15 percent. Assuming there is no new information released about the company, how much do you expect the company's stock to trade for tomorrow? (Do not round the intermediate calculation. Round your final answer to two decimal places) A) $21.70 B) $21.65 C) $21.60 D) $21.55 Ans: A Feedback: The price would be expected to drop by the amount investors receive after taxes ($0.30 + $0.05)× 85% = $0.2975 The new stock price would be $22.00 − $0.2975 = $21.70

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. Bright Capital, Inc. is being liquidated. The company's assets can be sold for $20 million. It will cost $18 million for the company to meet all its previous obligations and to pay-off debt holders. The company has 30 million shares outstanding. If you own 2,000 shares, how much do you expect to receive in liquidating dividends? Ignore taxes. (Round your final answer to two decimal places.) A) $0.00 B) $133.33 C) $266.66 D) $1,200.00 Ans: B Feedback: Shareholders will receive the residual claim after other claimholders have been paid $20 million − $18 million = $2 million This $2 million will be distributed on a pro-rata basis. As a holder of 2,000 shares, you will receive $2 million × (2,000 shares / 30 million shares) = $133.33

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. You own 20,000 shares of stock in Casi-knows, Inc. which has just sold one of its large resort hotels for $300 million. Management intends to return the entire revenue from the sale to shareholders by issuing a special dividend. If Casi-knows has 20 million shares outstanding, how large a dividend payment do you expect to receive? A) $20,000 B) $200,000 C) $300,000 D) $1,000,000 Ans: C Feedback: The $300 million will be distributed on a pro-rata basis. You will receive $300 million × (20,000 shares / 20 million shares) = $300,000.

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. Earmark, Co. has a policy of returning a minimum of 40 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.35 per share. In each of the first three quarters the company paid a regular cash dividend of $0.10 per share. What combination of dividends could the company's board approve to meet their target payout percentage? A) A regular cash dividend of $0.10 per share. B) A regular cash dividend of $0.10 per share and an extra dividend of 0.56 per share. C) A regular cash dividend of $0.10 per share and an extra dividend of $0.46 per share. D) A regular cash dividend of $0.10 per share and an extra dividend of $0.16 per share. Ans: D Feedback: The company earned $0.35 × 4 quarters = $1.40 per share this year. To achieve the 40 percent target, the firm must distribute $1.40 × 40% = $0.56 per share to shareholders. The company has already distributed $0.10 × 3 quarters = $0.30 per share. The company could meet the target by distributing another $0.26 per share through a regular dividend of 0.10 per share and an extra dividend of 0.16 per share.

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. Lithion, Co. has a policy of returning a minimum of 25 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.20 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. What combination of dividends could the company's board approve to meet their target payout percentage? A) B)

A regular cash dividend of $0.05 A regular cash dividend of $0.05 per share and an extra dividend of 0.05 per share

A regular cash dividend of $0.05 per share and an extra dividend of $0.10 per share

A regular cash dividend of $0.05 per share and an extra dividend of $0.20 per share

Ans: A Feedback: The company earned $0.20 × 4 quarters = $0.80 per share this year. To achieve the 25 percent target, the firm must distribute $0.80 × 25% = $0.20 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. The company could meet the target by distributing another $0.05 per share through a regular dividend.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. Which of the following is NOT a possible result of a stock repurchase? A) Removing a large number of shares from circulation can change the ability of certain shareholders to control the firm. B) If the number of remaining shares is relatively small, the remaining shares will be less liquid. C) The debt-to-equity ratio will be increased. D) By repurchasing stock when it is undervalued, managers can effectively transfer value from stockholders who choose to sell their shares to stockholders choose to remain invested in the company. Ans: C

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. Which type of stock repurchase often takes place at a price below the current market price of the stock? A) Open-market repurchase B) Fixed-price tender offer repurchase C) Dutch auction tender offer repurchase D) Targeted stock repurchase Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. Which type of stock repurchase allows management to set the repurchase price at the lowest level necessary to repurchase the desired number of shares? A) Open-market repurchase B) Fixed-price tender offer repurchase C) Dutch auction tender offer repurchase D) All of these Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. Which of these actions could by itself have an impact on the control of a firm? A) A tender offer stock repurchase B) A special dividend payment C) A stock split D) A regular cash dividend payment Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. Venus Co. has just announced that the board has reached a targeted stock repurchase agreement with a large stockholder. The company will repurchase all of the large investor's stock for 90 percent of the current market value. When the stock repurchase was announced, the shares of Venus Co. fell by 7 percent. Which of these explanations could reasonably explain the drop in share price? A) The willingness of the large investor to accept the targeted stock repurchase signals that the large investor believes the company will not do well in the future. B) A targeted stock repurchase essentially transfers value from the average investor to the targeted investor. C) The investor believes that the company's management is entrenching itself by buying off any large block shareholders. D) Both The willingness of the large investor to accept the targeted stock repurchase signals that the large investor believes the company will not do well in the future and The investor believes that the company's management is entrenching itself by buying off any large block shareholders. Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. Neonia, Co. has a policy of returning a minimum of 25 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.25 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. The company has 2 million shares of common stock outstanding. What combination of dividends and stock repurchases could the company's board approve to meet their target payout percentage? A) A regular cash dividend of $0.05 B) A regular cash dividend of $0.05 per share and an open-market stock repurchase of $100,000 in stock C) A regular cash dividend of $0.05 per share and an open-market stock repurchase of $400,000 in stock D) A regular cash dividend of $0.05 per share and an open-market stock repurchase of 500,000 in stock Ans: B Feedback: The company earned $0.25 × 4 quarters = $1.00 per share this year. To achieve the 25 percent target, the firm must distribute $1.00 × 25% = $0.25 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. If the company issues another regular dividend of $0.05 per share, it will still have $0.05 per share to remaining to be returned to shareholders. The stock repurchase required to return that value would be (0.05 per share × 2 million shares) = $100,000 of stock repurchase.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. Calciya, Co. has a policy of returning a minimum of 40 percent of earnings to shareholders every year through dividend issues and open-market stock repurchases. In each quarter this year, the company earned $0.20 per share. In each of the first three quarters, the company paid a regular cash dividend of $0.05 per share. The company has 8 million shares of common stock outstanding. What combination of dividends and stock repurchases could the company's board approve to meet their target payout percentage? A) A regular cash dividend of $0.05 B) A regular cash dividend of $0.05 per share and an open-market stock repurchase of $960,000 in stock C) A regular cash dividend of $0.05 per share and an extra dividend of $0.12 D) Both A regular cash dividend of $0.05 per share and an open-market stock repurchase of $960,000 in stock and A regular cash dividend of $0.05 per share and an extra dividend of $0.12 Ans: D Feedback: The company earned $0.20 × 4 quarters = $0.80 per share this year. To achieve the 40 percent target, the firm must distribute $0.80 × 40% = $0.32 per share to shareholders. The company has already distributed $0.05 × 3 quarters = $0.15 per share. To meet the 40 percent target, the company must distribute another ($0.32 – $0.15) = $0.17 per share. The company could meet the target in two ways: 1. Either it could distribute another $0.17 per share through a regular dividend of $0.05 and an extra dividend of $0.12 per share, or; 2. The company could pay another $0.17 per share through a regular dividend of $0.05 and a stock repurchase of ($0.12 per share × 8 million shares) = $960,000 in stock.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 55. You purchased 3,000 shares of Space Apparition Co. four years ago at $40 per share. You have just received a mail from the company announcing a fixed-price tender offer stock repurchase at $70 per share. Capital gains are taxed at 20 percent. If you participate in the repurchase, how much will you receive? A) $31,500 B) $192,000 C) $178,000 D) $210,000 Ans: B Feedback: You will only be taxed on the capital gain. So you will receive 3,000 shares × ($40 + ($70 − $40) × 0.80) = $192,000.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 56. You purchased 3,000 shares of Purple Stuff Beverage Co. four years ago at $30 per share. You have just received a mailing from the company announcing a fixed-price tender offer stock repurchase at $36 per share. Capital gains are taxed at 15 percent. If you participate in the repurchase, how much will you receive? A) $18,000 B) $91,800 C) $105,300 D) $108,800 Ans: C Feedback: You will only be taxed on the capital gain. So you will receive 3,000 shares × ($30 + ($36 – $30) × 0.85) = $105,300.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 57. You purchased 2,500 shares of Digital Vision, Corp. several years ago for $40 per share. The company is offering a fixed-price tender offer repurchase for $54 per share. What is the amount of after-tax proceeds you would receive from taking part in the repurchase, if capital gains are taxed at 15 percent? A) $120,000 B) $121,250 C) $129,750 D) $135,000 Ans: C Feedback: You will only be taxed on the capital gain. So you will receive 2,500 shares × ($40 + ($54 − $40) × 0.85) = $129,750.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 58. Cosmic crew, Co has 3 million shares outstanding. The shares are currently selling for $40. If the firm repurchases $10 million worth of shares at market prices, approximately how much will the stock be worth after the repurchase? Ignore taxes. A) $40 B) $38 C) $42 D) $50 Ans: A Feedback: Before the repurchase, the firm was worth $40 per share × 3 million shares = $120 million. The number of shares the firm repurchased for $10 million at the market price of $40 = $10 million / $40 = 250,000 shares. After the repurchase, the firm has $120 million − $10 million = $110 million. The number of remaining shares = 3,000,000 – 250,000 = 2,750,000. So each share is worth $110,000,000 / 2,750,000 = $40

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 59. You purchased 500 shares in Catalyst, Inc. several years ago for $20. The company previously announced it will be distributing cash to shareholders in a novel way. First, the company will have a tender offer stock repurchase at $30 per share. After the repurchase, it will issue a special dividend of $5.00 per share to the remaining stockholders. Suppose that you want to convert your holdings in Catalyst, Inc. into cash. Assume the tax on dividends is 30 percent and the tax on capital gains is 15 percent. The shares are currently trading for $30. Assume no new information comes out about the company. How much cash will you receive from taking part in the repurchase? A) You will receive $14,250 by taking part in the repurchase. B) You will receive $15,000 by taking part in the repurchase. C) You will receive $15,750 by taking part in the repurchase. D) You will receive $16,000 by taking part in the repurchase. Ans: A Feedback: If you take part in the repurchase, you will have to pay taxes on your capital gains. So, the amount you will receive = 500 shares × ($20 + ($30 − $20) × 0.85 ) = $14,250

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 60. You purchased 500 shares in Div Choice, Inc. several years ago for $20. The company previously announced it will be distributing cash to shareholders in a novel way. First, the company will have a tender offer stock repurchase at $30 per share. After the repurchase, it will issue a special dividend of $5.00 per share to the remaining stockholders. Suppose that you want to convert your holdings in Div Choice, Inc. into cash. Assume the tax on dividends is 30 percent and the tax on capital gains is 15 percent. The shares are currently trading for $30. Assume no new information comes out about the company. Approximately, how much will you receive by waiting until after the ex-dividend day and then selling the shares in the market? (Do not round intermediate calculation. Round your final answer to the nearest dollar.) A) You will receive about $13,500 by selling after the ex-dividend day. B) You will receive about $14,775 by selling after the ex-dividend day. C) You will receive about $14,513 by selling after the ex-dividend day. D) You will receive about $15,000 by selling after the ex-dividend day. Ans: C Feedback: If you wait until the dividend payment, you will pay a 30 percent tax on the dividend, so you will receive $5 × 70% = $ 3.50 per share in dividends. However, we would expect the price of the stock to only fall by the after-tax amount of the dividend. So the stock will be worth about $30 − $3.50 = $26.50. Thus, from selling the stock you will receive = ($20 + ($26.50 − $20) × 0.85) = $25.525 per share. In total, you will receive ($25.525+ $3.50) × 500 shares = $14,512.50 or $14,513.00.

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 61. Which of the following explanations is NOT a possible benefit of dividends? A) Some investors prefer dividend-paying stocks and will be willing to pay a higher price for stocks with regular dividends. B) Paying out large regular dividends can force management to regularly raise more capital. The extra scrutiny involved in raising capital can increase the incentives of management to run the company efficiently. C) Dividends can be used to manage the capital structure of a company. D) Paying dividends reduces the probability that a firm will enter financial distress. Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comrpehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. Which of the following statements about the relative advantages of stock repurchases over dividends is NOT true? A) Since most ongoing stock repurchase programs are as visible as dividend programs, they can be used effectively to send a positive signal about a firm’s prospects to investors. B) Open-market stock purchases allow management more flexibility because investors are less likely to react if the management cuts back or ends a stock repurchase as compared to cutting back on dividend payments. C) Stock repurchases allow stockholders to choose whether or not to participate in the stock repurchase. This allows stockholders to have more control over their tax burden. D) Historically, taxes on dividend payment have been higher than those on stock repurchases. Ans: A

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. In early 2003, the U.S. government cut the tax rate on dividends to a flat 15 percent instead of treating dividend payments as other income. All else being equal, how would we expect the number of companies paying dividends to change? A) We would expect the number of dividend-paying companies to increase. B) We would expect the number of dividend-paying companies to decrease. C) We would expect the number of dividend-paying companies to stay relatively constant. D) None of these Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. Suppose you are advising a retiree who holds 2,000 shares of LargeDiv Corp. The company is largely held by tax-paying institutional investors and has announced that it will shortly be issuing a large dividend. Because the shares are held in the retiree's Roth IRA, she will not incur taxes on either capital gains or dividends. The retiree has decided to sell the shares sometime this year, and use the money for living expenses. You expect the only upcoming change in the stock price will result from the dividend. Ignoring any discounting for time, what advice should you give? A) Sell the stock now—the stock price is likely to decrease more than just the dividend amount. B) Sell the stock ex-dividend—the stock price is likely to decline, but by less than the dividend amount. C) Sell the stock—irrespective of when the stock is sold. D) Sell the stock now—it is always better to sell the stock immediately regardless of the tax consequences. Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 65. You purchased 2,000 shares of Crimson Treat Technologies several years ago at $50 per share. The company does not pay a regular cash dividend. You want to manufacture your own dividend by selling a little bit of stock each quarter. The company's stock is currently trading at $75. If capital gains are taxed at 15 percent, how many shares would you have to sell to receive $3,420 in cash? A) 27 shares B) 46 shares C) 48 shares D) 51 shares Ans: C Feedback: The after-tax amount received per share = ($50 + ($75 − $50) × 0.85) = $71.25. The number of shares to be sold = $3,420 / $71.25 = 48 shares.

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 66. You purchased 8,000 shares of Wallflower Technologies several years ago at $20 per share. The company does not pay a regular cash dividend. You want to manufacture your own dividend by selling a little bit of stock each quarter. The company's stock is currently trading at $60. If capital gains are taxed at 15 percent, how many shares would you have to sell to receive $2,000 in cash? (Round your final answer to the nearest unit of shares.) A) 30 shares B) 33 shares C) 37 shares D) 39 shares Ans: C Feedback: The after-tax amount received per share = ($20 + ($60 − $20) × 0.85) = $54. The number of shares to be sold = $2,000 / $54 = 37 shares.

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. You purchased 4,000 shares of High-Div Co. several years ago at $50 per share. The company has decided to pay a special dividend of $2.00 per share. Dividend payments are taxed at 15 percent. You intend to reinvest in the company through the dividend reinvestment program. If the company's stock is trading at $48.20 following the dividend payment, how many additional shares can you buy through the dividend reinvestment program? (Round your final answer to the nearest unit of shares.) A) 166 shares B) 141 shares C) 134 shares D) 125 shares Ans: B Feedback: The after-tax amount received = ($2.00 × 0.85) × 4,000 shares = $6,800. With the DRIP program, you will not have any transaction costs to reinvest. So you can buy ($6,800 / $48.20) shares = 141 shares

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. You own 7,000 shares of No-Drip Co. The company has decided to pay a special dividend of $1.00 per share. Dividend payments are taxed at 15 percent. You intend to reinvest your dividend back into the company, but the company does not have a dividend reinvestment program. To reinvest through your broker, you will have to pay a $46 commission. If the company's stock is trading at $12.43 following the dividend payment, how many additional shares will you be able to purchase? (Round your final answer to the nearest unit of shares.) A) 563 shares B) 481 shares C) 478 shares D) 475 shares Ans: D Feedback: The after-tax amount received = ($1.00 × 0.85) × 7,000 shares = $5,950. You will also have to pay the $46 transaction fee, leaving you with $5,904 to invest. So you can buy ($5,904 / $12.43) shares = 475 shares

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. The Dimples Golf Ball, Co. has paid a regular dividend of $0.20 quarterly for the last three years. The company has 2 million shares outstanding. Over the next year the company will have to spend $800,000 to service its debt and spend $200,000 in capital expenditures. The company has $500,000 of cash and cash equivalents. Over the next year how much cash must be provided from operations to continue to make the same quarterly dividend payment and still have $500,000 in cash at the end of the year? A) 1,000,000 B) 1,600,000 C) 2,000,000 D) 2,600,000 Ans: D Feedback: To continue the current dividend pattern, the company will need to pay ($0.20 per quarter × 4 quarter) × 2 million shares = $1,600,000. The company will also need ($800,000 debt payments + $200,000 Capital Expenditure) = $1,000,000. The company must maintain $500,000 cash and cash equivalents. The result is that to meet the dividend payments and other requirements operations must provide ($1,600,000 + $1,000,000) = $2,600,000.

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 70. The Wyoming Boot, Co. has paid a regular dividend of $0.25 quarterly for the last several years. The company has 1 million shares outstanding. Over the next year, the company will have to spend $600,000 to service its debt and spend $500,000 in capital expenditures. The company has $600,000 of cash and cash equivalents. Over the next year, how much cash must be provided from operations to continue to make the same quarterly dividend payment and still have $250,000 in cash at the end of the year? A) 1,000,000 B) 1,100,000 C) 1,750,000 D) 2,100,000 Ans: C Feedback: To continue the current dividend pattern, the company will need to pay ($0.25 per quarter × 4 quarter) × 1 million shares = $1,000,000. The company will also need ($600,000 debt payments + 500,000 capital expenditures) = $1,100,000. The company can take ($600,000 − $250,000) = $350,000 from cash and cash equivalents and still have the necessary cash for next year. The result is that to meet the dividend payments and other requirements, operations must provide ($1,000,000 + $1,100,000 − $350,000) = $1,750,000.

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. Suppose you own shares of ThreeFor, Inc. which has just announced a 3-for-1 stock split. Immediately after the announcement, the price of the company's shares rose by 5 percent. You don't expect any new information about the company until after the stock split. Ignoring any discounting for time, if you intend to sell your shares soon, you should A) sell the stock now—the single share you have now is likely to be worth more than the three shares you'll have after the split. B) sell the stock after the split—typically, the marker reacts positively to stock splits. The three shares you'll have after the split will be worth more than the single share you have now. C) sell the stock now—the stock is likely to be more liquid before the split when there are fewer shares. D) sell the stock—irrespective of when the stock is sold. If there is no new information about the stock, then the value of three shares after the split should be the same as the value of the single share you hold now. Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comrpehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Generally, management undertakes a reverse stock split to A) send a signal to investors that the company is expected to perform poorly. B) meet the minimum requirements to be listed on one of the major stock exchanges. C) increase the liquidity of shares by decreasing the number of share available. D) reduce the administrative costs associated with investor relations. Ans: B

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 73. Split-Gram, Inc. has announced a 4-to-1 stock split. If the company currently has 1 million shares outstanding, how many outstanding shares will it have after the split? A) 4 million B) 3 million C) 2 million D) 1 million Ans: A Feedback: The company had 1 million shares outstanding and is issuing a 4-for-1 stock split. The no. of outstanding shares after the split = 4 × 1 million = 4 million.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 74. You own 3,000 shares of Split-Holdings Co. The shares are currently selling for $48. The company has just announced a 4-for-1 stock split. How many shares will you own after the split, and approximately what will your holdings in Split-Holdings Co. be worth? A) 12,000 shares worth about $144,000 B) 12,000 shares worth about $576,000 C) 15,000 shares worth about $144,000 D) 15,000 shares worth about $720,000 Ans: A Feedback: You own 3,000 shares of a company that is undergoing a 4-for-1 split. You will have: 4 × 3,000 = 12,000 shares After the split, each share will be worth one-fourth of the original share price, so your total holding will be worth,($48 / 4 ) × 12,000 = $144,000.

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 75. Split-Div, Inc. has issued quarterly dividends of $0.10 per share each quarter over the last few years. This quarter the company initiated a 2-for-1 stock split. What is the minimum quarterly dividend the company’s board should approve to avoid sending a bad signal to the investors? A) $0.02 per share B) $0.05 per share C) $0.10 per share D) $0.20 per share Ans: B Feedback: To avoid sending a bad signal to the investors, the company needs to pay out the same dividend relative to the number of outstanding shares. After a 2-for-1 split, the equivalent regular cash dividend would be $0.10 / 2 = $0.05.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 76. You own 1,200 shares of Harry, Co. The company has recently announced a 1-for-3 reverse stock split. How many shares will you own after the reverse split? A) 300 shares B) 400 shares C) 3,600 shares D) 4,800 shares Ans: B Feedback: You own 1,200 shares. After a 1-for-3 reverse stock split, you would own 1,200 / 3 = 400 shares.

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 77. Pluto, Co. stock is currently trading for $54. Assume there is no new information about the company. If the company issues a 10 percent stock dividend, what will the approximate price of the stock be after the stock dividend is issued? (Round your final answer to two decimal places.) A) $47.80 per share B) $48.60 per share C) $49.09 per share D) $54.00 per share Ans: C Feedback: After the stock dividend, there will be 110 percent more shares representing the same amount of assets: $54 / 110% = $49.09 per share.

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 78. Which of the following statements describes the finding from academic studies on corporate dividend policy? A) Managers tend to increase regular cash dividends in response to unexpectedly high earnings. B) Managers tend to maintain a level dividend payment at an amount that they are relatively certain they can maintain in the future. C) Managers tend to focus on dividends rather than stock repurchases because institutional investors tend to prefer regular dividends. D) Dividend policy doesn't matter because investors can re-create dividends by selling a fraction of their shares. Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 79. Which of the following considerations should NOT be related to management's concerns when setting a stock repurchase policy? A) Over the long term, how much does a company's level of earnings exceed its investment requirements? How certain is this level? B) Is the stock currently undervalued? Can the management add value to the company by initiating a stock repurchase? C) Does a firm have enough financial reserves to meet the short-term obligations in periods when earnings are down or investment requirements are up? D) Can a firm quickly raise equity capital if necessary? Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 80. GoodSignal Co. is currently trading for $10 with 1 million shares outstanding. Which of the following actions would be the most credible signal that management believes that the longterm prospects for a company have improved? A) Pay a $0.20 extra dividend in addition to the company's $0.20 regular quarterly dividend B) Increase the company's regular quarterly dividend from $0.20 to $0.40 C) Initiate an open-market stock repurchase of 2 percent of the company's stock D) Pay a $0.20 special dividend by selling a major fixed asset Ans: C

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Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowlege AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 81. Describe the four general types of cash dividends and the purpose of each. Ans: The most common form of a dividend is known as the regular cash dividend, which is paid on a regular basis. It is typically set at a level that management generally expects the company to be able to maintain in the long run, barring major changes in the fortune of the firm. The extra dividend is generally paid when a firm has earnings that are higher than expected. The special dividend is a one-time payment to stockholders and is used to distribute large amounts of cash. It may be used to distribute the proceeds from the sale of a major asset or business or even to alter the capital structure of the firm. A liquidating dividend is paid to stockholders when a firm is liquidated and will no longer continue doing business. The proceeds from the liquidating dividend are available only after all creditors and priority claimants are paid.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 82. Discuss why investor perception of a stock repurchases is weaker than that of a cash dividend. Ans: While repurchases give investors the flexibility to choose whether or not they would like to receive a dividend, the major weakness in a repurchase lies in the fact that when a company publicly announces an ongoing open-market repurchase program, investors know that management can cut back on the repurchase or end them at any time. This makes the commitment to pay out cash weaker than with a dividend, and it means that if cash flows are less certain, then managers are likely to prefer to distribute extra cash by repurchasing shares, where there is some flexibility in following through.

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: ComprehensionAASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 83. In the 2005 follow-up to the Lintner study, the researchers found that managers choose their firm's dividend policies in a way that enables them to continue making the investments necessary for a firm to complete in its product markets. What does this imply about a firm that operates in a low-growth industry? Ans: Since managers appear to be sensitive to not having the ability to take on positive-NPV projects because of a lack of financing, then it appears that managers would like to create a buffer of cash, causing a low-dividend payout, in order to be able to invest in these projects. On the other hand, if a firm does not have many growth prospects, and consequently no new positive-NPV projects, then the firm should have a higher dividend payout than a similarly successful firm in a higher growth industry.

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Chapter 18: Business Formation, Growth, and Valuation Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

1. Starting a business is less risky than buying and growing a business that someone else has already established. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

2. The founder of a company needs to be a part of many critical decisions taken by the board but need not be a part of any related to strategies to sell the firm's products. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

3. Businesses fail because of the management's inability to accurately estimate the amount of funds required to get their businesses up and running. A) True B) False Ans: A

18-1

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

4. Access to capital for a sole proprietorship is excellent compared to a C-Corporation. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

5. A business at the start up has a better chance to succeed if calculated risks are taken. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

6. A limited liability company, LLC, leads to unlimited liability for the people who make a business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

7. Limited liability partnerships are inexpensive to form compared to sole proprietorships. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

8. Limited partnerships are more costly to form than sole proprietorships because the partners must hire an attorney to draw up and maintain the partnership agreement. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

9. The downside of being able to raise equity capital from other people is that an entrepreneur must inevitably share control with other investors. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

10. An S-corporation allows the stockholders to avoid double taxation but places limits on the ownership of the firm's stock. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

11. An S-corporation can have no more than 50 stockholders. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

12. Corporations, which are “legal persons” under state law, automatically have a finite life. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

13. The two tools that are particularly useful in understanding the cash requirements of a business and in estimating how much financing a new business will require are the cash flow break-even analysis and the cash budget. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

14. The cash flow break-even analysis helps identify how much money will be needed to launch a new product or business. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

15. A cash budget summarizes the cash flows into and out of a firm over a period of time. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

16. A business plan presents the results from a strategic planning process that focuses on how a business will be developed over time. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

17. A business plan includes a detailed discussion of the marketing and sales activities that will enable a business to achieve the sales and margin levels reflected in the financial forecasts. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

18. An important thing to remember in valuing a business is that the value of a business changes over time. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

19. Decision makers must understand business valuation concepts in order to be able to identify the optimal capital structure and payout policy A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

20. A strategic investor is interested in buying the firm and not just its financial performance. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

21. Cost approaches include replacement cost and multiples analysis. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

22. The adjusted book value approach is useful in valuing holding companies whose main assets are publicly traded or other investment securities, but it is generally less applicable for operating businesses. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

23. In the transaction analysis approach, analysts use the information on what someone has paid for a comparable company in a merger or an acquisition to estimate a value for the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

24. In the free cash flow to equity (FCFE) approach, an analyst values the free cash flows that the assets of the firm are expected to produce in the future. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

25. The free cash flow from the firm (FCFF) approach uses only the portion of the cash flows that are available for distribution to stockholders. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

26. In contrast to the free cash flow to equity, FCFE, approach, which values cash flows that are available for distribution to stockholders, the dividend discount model, DDM, approach values the stream of cash flows that stockholders expect to receive through dividend payments. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

27. In contrast to the financial statements of publicly held firms, private company financials often include personal expenses of the owner and excess compensation expenses. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

28. Differences in marketability can result in premiums of 30 percent or more for shares of private companies. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

29. An important issue that must be considered when valuing a business is whether a controlling ownership interest or a minority interest is being valued. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

30. In valuing a business, analysts must also consider whether it is appropriate to adjust the estimated value of the business for the likelihood that the “key people” may not remain with the firm as long as expected. A) True B) False Ans: A

Page 10

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

31. During the startup of a company, the founder makes several critical decisions including: A) innovating the product(s) to sell. B) formulating the best marketing strategy for selling the products manufactured. C) raising the funds necessary to develop the product(s). D) formulating an efficient plan for its expansion. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

32. In which of the following forms of business organization access to capital is the least? A) A sole proprietorship B) A general partnership C) An S-corporation D) A C-corporation Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

33. The ability to make the life of a business independent of that of the founder increases the _____ of the ownership interests, making it easier for the business to raise capital. A) non convertibility B) liquidity C) limitation D) risk Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

34. A business's chances of success improve if you: A) jump into a business with capital that is just enough to set up a business. B) overanalyze opportunities to the point where you are just convincing yourself not to proceed. C) take reasonable risk. D) have a unique idea even if the strategy is poor. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

35. The life of an entity is flexible for: A) a general partnership. B) a sole proprietorship. C) an S-corporation. D) a C-corporation. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

36. A limited liability partnership is: A) a partnership agreement which can never be written for a fixed life. B) less costly to form than sole proprietorships. C) an agreement where partners face the possibility that their personal assets can be taken from them to satisfy claims on their businesses. D) less constrained than general partnerships because they can raise money from limited partners. Ans: D

Page 12

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

37. Which of the following statements is true of limited liability company? A) Limited liability company is no more costly to form than sole proprietorships. B) Like a corporation, an LLC provides limited liability for the people who make the business decisions in the firm while enabling all investors to retain the tax advantages of a limited partnership. C) The lives of limited liability company are not flexible. D) Limited liability company is more constrained than general partnerships because they can raise money only from members. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

38. Which of the following statements is true of a corporation? A) An S-corporation can have no more than 500 stockholders. B) All profits of an S-corporation do not pass directly to the stockholders as they would pass to the partners in a partnership. C) Profits earned in C-corporations are taxed only once at the corporate tax rate. D) S-corporations have less limited access to capital compared to C-corporations. Ans: D

Page 13

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

39. Which of the following statements is true of S-corporation? A) An S-corporation can have more than 100 stockholders. B) All profits of an S-corporation pass directly to the stockholders as they would pass to the partners in a partnership. C) An S-corporation is a variation of the LLC (limited liability company). D) Only foreign investors can own the shares of an S-corporation. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

40. Which of the following statements is true of sole proprietorship? A) A sole proprietorship is the most expensive type of business to start. B) The life of a sole proprietorship is limited. C) Sole proprietorships must rely on equity contributions from the public. D) The liability of owners of a sole proprietorship is limited. Ans: B

Page 14

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

41. Which of the following statements is true of cash flow break-even analysis? A) It is useful in understanding the cash requirements of a business and in estimating how much financing a new business will require. B) As per the cash flow break-even analysis, the cash flow break-even point calculation usually focuses on the computation of EAT break-even. C) It summarizes the cash flows into and out of a firm, usually on monthly basis. D) It helps an entrepreneur in understanding where the money is coming from and where it is going. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

42. Which of the following statements is true about a cash budget? A) Cash budget helps an entrepreneur understand the concept of EBITDA breakeven and how to calculate this point for each product a business’s produce. B) Cash budget focuses on the importance of maximizing a product’s per unit contribution. C) Cash budget provides a means of estimating how long it will take for a product to reach the break-even point and, therefore, how much money will be needed to launch a new product. D) Cash budget summarizes the cash flows into and out of a firm over a period of time. Ans: D

Page 15

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

43. Which of the following statements is true about business plans? A) A well-prepared business plan always avoids contingent liabilities as the plan helps to predict and change the occurrence of a contingent liability. B) A business plan is useful only in case of exigency in the business environment otherwise a business plan is not important. C) A business plan is a trivial part in the overall strategy formulation and its impact on business operations in the long run is miniscule. D) A well-prepared business plan makes it easier for an entrepreneur to communicate to potential investors precisely what returns an investor might expect to receive. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

44. _____ is a road map for a business. A) A cash budget B) A cash flow break-even analysis C) A business plan D) A transaction analysis Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

45. Which of the following mathematical expressions is used while calculating the value of a firm using the income approach? A) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years + The present value of all free cash flows after year T + The value of all of the nonoperating assets in the firm B) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years – The present value of all free cash flows after year T – The value of all of the nonoperating assets in the firm C) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years + The present value of all free cash flows after year T – The value of all of the nonoperating assets in the firm D) The present value of the free cash flows (FCF) that a business is expected to produce over the next T years – The present value of all free cash flows after year T + The value of all of the nonoperating assets in the firm Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

46. Decision makers must understand business valuation concepts in order to be able to: A) prepare the financial statements of the business. B) identify the optimal capital structure and the payout policy. C) identify the break-even point and the payout policy. D) calculate the deferred tax assets. Ans: B

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

47. Which of the following statements is true about business valuation? A) The valuation of business is solely about how much return a business provides to its stockholders. B) There is a single value for any business. C) There is no such thing as the value for a business. D) The value of a business is solely affected by investment managers’ decision. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

48. The value of a business changes over time because: A) the impact of the business valuation is minimized when timed properly. B) the risk involved in operations do not change. C) the estimates reflects the timing of what economic, industry, and firm conditions are at the time of valuation. D) the factors influencing the valuation can be controlled. Ans: C

Page 18

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

Note: Wording changed to match text 49. Which of the following statements is true of business valuation principle? A) As per first valuation principle, the value of business does not change over time. B) The value of a business is solely affected by managers’ financing decisions. C) The fair market value of a business is the value of that business to a hypothetical person who is knowledgeable about the business. D) Estimating the fair market value of a business includes the value of synergies or the effects of any investor-specific management style. Ans: C

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

50. Which of the following statements is true of replacement cost approach? A) Replacement cost is an income-based valuation approach. B) This approach should include only tangible assets, whether they are actually included on the accounting balance sheet or not. C) The replacement cost of a business is the cost of duplicating the assets of the business in their present form as of the valuation date. D) The replacement cost valuation approach is generally used to value the whole of assets within a business when they are being insured. Ans: C

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

51. The adjusted book value approach involves: A) restating the value of the individual assets in a business to reflect their historical costs. B) valuing individual assets within a business when they are being insured, but it is rarely used to value an entire business. C) the cost of duplicating the assets of the business in their present form as of the valuation date. D) valuing all tangible and intangible assets. Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

52. When using the multiples analysis approach to valuing a business, one must be aware: A) of the presence of a marketability premium that can be sizable. B) of the adjusted book value of a business which is the cost of duplicating the assets of the business in their present form as of the valuation date. C) of the stock value of similar companies whose shares are not publicly traded. D) of the presence of a marketability discount that can be sizable. Ans: D

Page 20

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

53. The transaction approach is difficult to use because: A) transactions data are typically as reliable as the data available for multiples analysis, especially when they are associated with a private firm. B) transactions involving the purchase or sale of an entire business in an industry tend to occur frequently and hence the amount of data is immense. C) the terms of the transactions can be easy to assess. D) the terms of the transactions can be difficult to assess. Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

54. Which of the following statements about the free cash flow from the firm (FCFF) approach is true? A) The present value of these cash flows exceeds the total value of the firm, or its enterprise value. B) We include the cash necessary to pay short-term liabilities that do not have interest charges associated with them, such as accounts payable and accrued expenses. C) The costs associated with noninterest-bearing current liabilities, which are included in the firm's cost of sales and other operating expenses, are added in the calculation of FCFF. D) The total value of the firm, VF, is computed as the present value of the FCFF, discounted by the firm's weighted average cost of capital, WACC. Ans: D

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

55. The costs associated with noninterest-bearing current liabilities, which are included in the firm's cost of sales and other operating expenses: A) are subtracted in the calculation of free cash flow from the firm (FCFF). B) are added in the calculation of FCFF. C) are not a factor in the calculation of FCFF. D) are added to the value of equity claims. Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

56. In the free cash flow from the firm (FCFF) approach, the total value of the firm, VF, is computed as the present value of the FCFF: A) discounted by the firm's cost of equity. B) discounted by the firm's WACC. C) discounted by the firm's cost of debt. D) discounted by the inflation rate prevailing in the economy. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

57. The free cash flow to equity (FCFE) approach uses only the portion of the cash flows that are available: A) for distribution to bondholders. B) for distribution to bondholders and stockholders. C) for distribution to stockholders. D) for distribution to board of directors. Ans: C

Page 22

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

58. The three specific cash flows associated that are included in the free cash flow to equity (FCFE) approach are: A) the interest expense on existing debt, the repayment of debt principal, and the proceeds from new debt issues. B) the interest expense on existing term debt, the repayment of debt principal, and the proceeds from new equity issues. C) the interest expense on existing debt, the repayment of debt principal, and the payment of dividends. D) the interest expense on existing debt, the repayment of debt principal, and the payment of dividends. Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

59. In contrast to the FCFE approach, the dividend discount model (DDM) approach values: A) cash flows that are available for distribution to stockholders. B) the stream of cash flows that stockholders expect to receive through dividend payments. C) the stream of cash flows that stockholders expect to receive through bonus issue. D) the stream of cash flows that stockholders expect to receive through stock repurchase. Ans: B

Page 23

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

60. Important issues that one must consider in valuing young private firms include: A) whether key people remain in the firm, the amount of dividends that one may receive in the coming years, and whether a controlling ownership interest or a minority interest is being valued. B) the difficulty in valuing young, rapidly growing companies in contrast to mature, stable companies, the amount of dividends that one may receive in the coming years, and whether a controlling ownership interest or a minority interest is being valued. C) the difficulty in valuing young, rapidly growing companies in contrast to mature, stable companies, whether key people remain in the firm, and whether a controlling ownership interest or a minority interest is being valued. D) whether the key people remain in the firm, the pretax operating cash flows generated by the firm in the coming years, and whether a controlling ownership interest or a minority interest is being valued. Ans: C

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

61. Sonicmony Soft, makes designer gold bracelets. Its annual costs include shop rent of $15,000, salaries for two jewelers of $125,000, design software costs of $12,000, and other overhead costs of $15,000. An average bracelet is priced at $6,500. It costs $2,200 in raw material, $1,500 in labor, and $400 in other expenses. What is the minimum number of bracelets that need to be sold to earn a profit? (Round to nearest whole unit.) A) 18 bracelets B) 47 bracelets C) 70 bracelets D) 14 bracelets Ans: C Feedback: Fixed costs = $15,000 + $125,000 + $12,000 + $15,000 = $167,000 Unit variable costs = $2,200 + $1,500 + $400 = $4,100 Unit selling price = $6,500 Therefore,

$167,000 = 69.58 bracelets $6,500 – $4,100 The firm needs to sell at least 70 bracelets annually before it can make a profit. =

Page 25

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

62. Atamony makes circuit boards and markets them to electronic goods manufacturers. The firm has nonsalary fixed costs of $112,000 and salary costs of $64,250. Each circuit board is sold at a price of $69 and involves variable costs of $46 per unit. What is the break-even point for Atamony? (Round to nearest whole unit.) A) 5,105 circuit boards B) 7,663 circuit boards C) 6,237 circuit boards D) 2,714 circuit boards Ans: B Feedback: Fixed costs = $112,000 + $64,250 = $176,250 Unit variable costs = $46 Unit selling price = $69 Therefore,

$176,250 = 7,663.04 circuit boards $69 – $46 The firm needs to sell at least 7,663 circuit boards annually before it can make a profit. =

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

63. Warren Soft makes period pieces. The firm has total fixed costs of $500,000. The average piece is sold at a price of $2,500 and involves variable costs of $1,800 per unit. What is the break-even point for this firm? (Round to nearest whole unit.) A) 714 pieces B) 928 pieces C) 617 pieces D) 738 pieces Ans: A Feedback: Fixed costs = $500,000 Unit variable costs = $1,800 Unit selling price = $2,500 Therefore,

$500,000 = 714.29 pieces $2,500 – $1,800 The firm needs to sell at least 714 pieces of furniture annually before it can make a profit. =

Page 27

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

64. Neucon company needs to sell 6,000 circuit breakers to break even. Its unit variable cost is $441, and its unit selling price is $800. What is the fixed cost of this company? A) $1,497,250 B) $2,154,000 C) $2,855,250 D) $4,652,500 Ans: B Feedback: Break-even point = 6,000 units Unit variable costs = $441 Unit selling price = $800

The firm has fixed costs of $2,154,000.

Page 28

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

65. FifeSiete Corp. wants to break even at 15,000 units on its only product. Its unit variable cost is $55, and its fixed cost is $750,000. What should be the company's unit selling price? A) $85 B) $92 C) $105 D) $78 Ans: C Feedback: Break-even point = 15,000 units Unit variable costs = $55 Fixed costs = $750,000

$750,000 Price – $55 $750,000 Unit selling price = 15,000 The firm has to sell its product at $105 15,000

Page 29

+ $55

= $105

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

66. Settetocol, Inc., has cash of $12,000, receivables of $35,000, and inventory of $28,000. In addition, the firm has fixed assets of $120,000. Management has also told you that you can reasonably expect to collect 93 percent of the receivables, that the inventory could be sold to realize 84 percent of its book value, and that the sale of the property, plant, and equipment would yield $94,000. What is the liquidation value of this company? (Round to the nearest dollar.) A) $162,070 B) $139,695 C) $174,866 D) $138,695 Ans: A Feedback: The liquidation value is Cash $12,000 × 100% = $12,000.00 Accounts receivable $35,000 × 93% = $32,550.00 Inventory $28,000 × 84% = $23,520.00 Net PP&E $120,000 $94,000.00 Total assets $195,000 $162,070.00

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

67. Foursonic Labs has cash of $26,000, receivables of $85,000, and inventory of $118,000. In addition, the firm has property, plant, and equipment of $165,000. Management has also told you that you can reasonably expect to collect 89 percent of the receivables, that the inventory could be sold to realize 85 percent of its book value, and that the sale of the property, plant, and equipment would yield $125,000. What is the liquidation value of this company? (Round to the nearest dollar.) A) $201,950 B) $229,000 C) $394,000 D) $326,950 Ans: D Feedback: The liquidation value is Cash $26,000 × 100% = $ 26,000 Accounts Receivable $85,000 × 89% = $ 75,650 Inventory $118,000 × 85% = $ 100,300 Net PP&E $165,000 $ 125,000 Total assets $394,000 $ 326,950

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

68. FifeSiete. has debt of $230 million and generated a net income of $121 million in the last fiscal year. In attempting to determine the total value of the firm, an investor identified a similar firm in Neuncon, Inc., an all-equity firm. This firm had 150 million shares outstanding, a share price of $14.25, and net income of $182 million. What is the total value of FifeSiete? (Round to the nearest million dollars.) A) $1,421 million B) $1,651 million C) $1,191 million D) $1,715 million Ans: B Feedback: The P/E multiple for Neuncon Inc. is: Total equity ($14.25 150, 000, 000) P/E = = = 11.74 Net income $182, 000, 000 Implied equity value for FifeSiete: VE = P / E  Net income = 11.74  $121, 000, 000

= $1, 420,540, 000 Value of FifeSiete's debt = VD = $230 million Therefore, the implied total value of FifeSiete is: VF = VE + VD = $1,420.54 + $230.00 = $1,650.54 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

69. Cervil had an EBIT of $247 million in the last fiscal year. Its depreciation and amortization expenses amounted to $84 million. The firm has 135 million shares outstanding and a share price of $12.80. A competing firm that is very similar to Cervil has an enterprise value/EBITDA multiple of 5.40. What is the enterprise value of Cervil? (Round to the nearest million dollars.) A) $1,334 million B) $453 million C) $1,787 million D) $1,315 million Ans: C Feedback: The enterprise value/EBITDA multiple for Cervil's competitor = 5.40 Cervil's EBITDA = EBIT + D&A = $247 million + $84 million = $331 million Cervil's enterprise value is: VF = Multiple  EBITDA = 5.40  $331 million = $1, 787.4 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

70. Cervil had an EBIT of $247 million in the last fiscal year. Its depreciation and amortization expenses amounted to $84 million. The firm has 135 million shares outstanding and a share price of $12.80. A competing firm that is very similar to Cervil has an enterprise value/EBITDA multiple of 5.40. What is the value of Cervil's debt? (Round to the nearest million dollars.) A) $121 million B) $165 million C) $97 million D) $59 million Ans: D Feedback: No. of shares outstanding = 135 million Share price = $12.80 Value of Cervil's equity = VE = $12.80 × 135 million = $1,728 million Cervil's enterprise value = $1,787.4 million Cervil's debt value = VD = VF – VE = $1,787.4 – $1,728 = $59.4 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

71. Factrack Inc., a biotech firm, is expected to grow rapidly in the next three years and then have a level growth rate for the foreseeable future. The firm expects free cash flows of $342.5 million, $512.3 million, and $750 million over the next three years, and thereafter its cash flows will grow at a steady rate of 8 percent per annum. The company has no nonoperating assets (NOA). If the appropriate WACC is 11.25 percent, what is the enterprise value of this business? (Round to the nearest million.) A) $19,367 million B) $18,101 million C) $26,190 million D) $24,923 million Ans: A Feedback: Cost of capital = WACC = 11.25% The present value of the cash flows in the first three years is: $342.5 $512.3 $750.0 PV ( FCFF3 ) = + + 2 (1.1125) (1.1125) (1.1125)3 = $307.87 + $413.93 + 544.70 = $1, 266.50 million Free cash flows in year 4 = $750 million × (1.08) = $810 million $810 TV 3 = = $24,923.08 0.1125 – 0.08 Terminal value = The present value of the terminal value is: PV (TV 3 ) =

TV 3

24,923.08

= $18,100.96 millions 3 (1+WACC ) (1.1125) Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $1,266.5 + $18,100.96 + $0 = $19,367.46 million 3

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

72. ProtoSeis Corp. is expected to grow rapidly in the next four years and then have a zero growth rate for the foreseeable future. The firm expects free cash flows of $42.5 million, $64.3 million, $77.1 million and $92 million over the next four years, and thereafter its cash flows will stay constant. The company has cash to the tune of $23.4 million. If the appropriate WACC is 10 percent, what is the enterprise value of this business? (Do not round intermediate computations. Round final answer to the nearest million.) A) $628 million B) $864 million C) $811 million D) $818 million Ans: B Feedback: Cost of capital = WACC = 10.0% The present value of the cash flows in the first four years is: $42.5 $64.3 $77.1 $92.0 PV ( FCFF4 ) = + + + 2 (1.10) (1.10) (1.10)3 (1.10) 4

= $212.54 million Free cash flows in year 5 = $92 million $92 TV = = $920 million 0.10 − 0.00 Terminal value = The present value of the terminal value is:

Nonoperating assets = NOA = $23.4 million Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $212.54 + $628.37 + $23.4 = $864.31 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

73. Symbyrec Phonic, an electronics manufacturer, is expected to grow rapidly in the next five years and then have a stable growth rate for the foreseeable future. The firm expects free cash flows of $262.5 million next year. These cash flows are expected to grow at a 30 percent rate over the following four years, and thereafter its cash flows will grow at a steady rate of 6 percent per annum. The company has nonoperating assets (NOA) of $31 million in the form of cash. If the appropriate WACC is 9 percent, what is the enterprise value of this business? (Do not round intermediate computations. Round final answer to the nearest million.) A) $26,490 million B) $22,222 million C) $19,014 million D) $22,191 million Ans: C Feedback: Cost of capital = WACC = 9.0% The present value of the cash flows in the first five years is: $262.5 $262.5(1.3) $262.5(1.3) 2 $262.5(1.3)3 $262.5(1.3) 4 PV ( FCFF5 ) = + + + + (1.09) (1.09) 2 (1.09)3 (1.09) 4 (1.09)5 = $1, 766.44 million Free cash flows in year 6 = $749.73 million × (1.06) = $794.71 million $794.71 TV 5 = = $26,490.33 million 0.09 – 0.06 Terminal value = The present value of the terminal value is: TV 5 $26,490.33 PV (TV 5) = = = $17,216.90 million (1+WACC )5 (1.09)5 Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $1,766.44 + $17, 216.90 + $31.00 = $19,014.34 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

74. Simpltar Co. is expected to grow rapidly in the next three years and then have no growth for the foreseeable future. The firm expects free cash flows of $9.1 million, $11.4 million, and $17.7 million over the next three years, and thereafter its cash flows will stay constant. The company has no nonoperating assets. If the appropriate WACC is 12 percent and debt of 44.5 million, what is the equity value of this business? (Round final answer to the nearest million.) A) $135 million B) $105 million C) $45 million D) $90 million Ans: D Feedback: Cost of capital = WACC = 12.0% The present value of the cash flows in the first three years is: $9.1 $11.4 $17.7 PV ( FCFF3 ) = + + (1.12) (1.12)2 (1.12)3

= $29.81 million Free cash flows in year 4 = $17.7 million Terminal value = The present value of the terminal value is: TV3 $147.5 PV (TV3 ) = = = $104.99 millions 3 (1 + WACC ) (1.12)3 Nonoperating assets = NOA = $0 Total enterprise value is, therefore VF = PV(FCFT) + PV(TVT) + NOA = $29.81 + $104.99 + $0 = $134.8 million Value of debt = VD = $44.5 million Value of equity = VE = $134.8 – $44.5 = $90.3 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

75. You are using the FCFF approach to value a business. The estimated FCFF for next year will be $13.6 million, and it will increase at a rate of 6 percent for each of the following five years. After that point, the FCFF will increase at a rate of 3 percent forever. If the WACC for this firm is 8 percent, what is it worth? (Round final answer to the nearest million.) A) $301 million B) $354 million C) $241 million D) $144 million Ans: A Feedback: Value of the FCFF for the first five years using the growing annuity formula = FCFF for year 1 = $13.6 million Cost of capital = WACC = 8.0%

$13.6 × 1 = 0.08 – 0.06

–

1.06 1.08

= $60.67 million Free cash flows in year 6 = FCFF1 × (1+g)4 × (1+gnormal) = $13.6 × (1.06)4 × (1.03) = $17.68 million Terminal Value

TV5 =

$17.68 0.08 – 0.03

$353.70 million

The present value of the terminal value is:

and the value of the firm is therefore: VF = $60.67 million + $240.72 million = $301.39 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

76. Phosfranc Inc. is valuing the equity of a company using the free cash flow from equity, FCFE, approach and has estimated that the FCFE in the next three years will be $6.25, $7.70, and $8.36 million respectively. Beginning in year 4, the company expects the cash flows to increase at a rate of 4 percent per year for the indefinite future. It is estimated that the cost of equity is 12 percent. What is the value of equity in this company? (Do not round intermediate computations. Round final answer to the nearest million.) A) $77 million B) $95 million C) $109 million D) $60 million Ans: B Feedback: Cost of equity = kE = 12.0% The present value of the cash flows expected over the next five years is: $6.25 $7.70 $8.36 PV ( FCFF3 ) = + + (1.12) (1.12)2 (1.12)3

= $17.67 million FCFF3 = FCFE3 as there is no debt component. The terminal value is: FCFE3  (1 + g ) $8.36  (1.04) TV3 = = = $108.68 million kE − g 0.12 − 0.04 The present value of the terminal value is: TV3 $108.68 PV (TV3 ) = = = $77.36 millions 3 (1 + kE ) (1.12)3 Therefore, if there are no nonoperating assets, the value of the equity is VF = $17.67 + $77.36 = $95.03 million

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

77. You are valuing the equity of NewNil Corp. using the FCFE approach and have estimated that the FCFE in the next three years will grow at 8 percent rate from last year's FCFE of $2.1 million. Beginning in year 4, you expect the cash flows to increase at a constant rate of 5 percent per year for the indefinite future. The cost of equity for the firm is10 percent. What is the value of equity in this company? (Round final answer to the nearest million dollars.) A) $42 million B) $56 million C) $48 million D) $6 million Ans: C Feedback: FCFE for year 1 = $2.1 million × (1.08) = $2.268 million Cost of equity = kE = 10.0% $2.268 $2.268(1.08) $2.45(1.08) PV ( FCFE3 ) = + + (1.10) (1.10) 2 (1.10)3

= $6.07 million The terminal value is: FCFE3  (1 + g ) $2.65  (1.05) TV3 = = = $55.55 million kE − g 0.10 − 0.05 The present value of the terminal value is: TV3 $55.55 PV (TV3 ) = = = $41.74 millions 3 (1 + kE ) (1.10)3 Therefore, if there are no nonoperating assets, the value of the equity is VF = $6.07 + $41.74 = $47.81 million

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

78. You are interested in investing in a private company. Based on earnings multiples of similar publicly traded firms, you estimate the value of the private company's stock to be $13.44 per share. You plan to acquire a majority of the shares in the company. The expected control premium is 12 percent, while the marketability discount for such a firm is 15 percent. The discount for the key person, one of the founders who may leave the firm upon your control of the firm, is 15 percent. What price should you be willing to pay for these shares? (Round final answer to two decimal places.) A) $14.92 per share B) $16.65 per share C) $11.80 per share D) $10.88 per share Ans: D Feedback: Value per share = Share value × [(1 + Control premium) × (1 – Marketability discount) × (1 – Key person discount) = $13.44 × (1 + 12%) × (1 – 15%) × (1 – 15%) = $10.88

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

79. Shuman Wolf is interested in investing in a private company. Based on earnings multiples of similar publicly traded firms, he estimates the value of the private company's stock to be $20 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 9 percent. Shuman estimates the marketability discount for such a firm to be 11 percent. The discount for the key person, one of the founders who may leave the firm upon Shuman's control of the firm, is 19 percent. What price should he be willing to pay for these shares? (Round final answer to two decimal places.) A) $16.47 per share B) $31.45 per share C) $15.72 per share D) $32.94 per share Ans: C Feedback: Value per share = Share value × [(1 + Control premium)×(1 – Marketability discount) × (1 – Key person discount) = $20 × (1 + 9%) × (1 – 11%) × (1 – 19%) = $15.72

Page 43

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

80. Alfred Sautin wants to invest in Dieciring, Inc., a private company. Based on earnings multiples of similar publicly traded firms, Alfred estimates the value of the private company's stock to be $19 per share. He plans to acquire a majority of the shares in the company. The expected control premium is 11 percent. He estimates the marketability discount for such a firm to be 14 percent. The discount for the key person, one of the founders who may leave the firm upon Alfred's control of the firm, is 16 percent. What price should he be willing to pay for these shares? (Round final answer to two decimal places.) A) $15.24 per share B) $18.10 per share C) $14.05 per share D) $20.70 per share Ans: A Feedback: Value per share = Share value × [(1 + Control premium) × (1 – Marketability discount) × (1 – Key person discount) = $19 × (1 + 11%) × (1 – 14%) × (1 – 16%) = $15.24

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Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

81. What difficulties are associated with valuing real assets compared to financial assets? Ans: The valuation of real assets, however, is less straightforward than the valuation of financial assets for several reasons. First, in many cases, cash flows for financial assets are well documented in a legal contract. If they are not, we are at least able to make some reasonable assumptions about what they are. For real assets, no such information exists. Specialists within the firm; usually from the finance, marketing, and production groups; prepare estimates of future cash flows for the capital project. Second, many financial securities are traded in public markets, and these markets are reasonably efficient. Thus, market data on rates of return are accessible. For real assets, no such markets exist. As a result, we must look at investors' opportunity cost, the rate of return they give up when they invest in real assets rather than financial assets. We must estimate required rates of return on real assets from market data on financial assets, which can be difficult to do.

Page 45

Format: Essay Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

82. Explain how valuations can differ between public and private companies and between young and mature companies as well as the importance of marketability, control, and key person considerations in valuation. Ans: Valuations differ between public and private companies for a number of reasons. Two reasons are the quality of the financial statements and the marketability of the securities being valued can differ considerably. Marketability is important because it affects the price that investors are willing to pay for a security. The less marketable a security is, the lower the price investors will be willing to pay. Young, rapidly growing companies tend to be more difficult to value than mature companies because there is less reliable historical information on young companies and the future of young companies tends to be less certain. Control is an important consideration in business valuation because having control of a business provides an investor with more flexibility with regard to how he or she will manage the business. Investors value this flexibility and will, therefore, pay more for a controlling interest in a company. If the cash flows that a business is expected to generate depend heavily on certain employees, those employees are key people. When valuing a business, an analyst must account for the possibility that the key people will unexpectedly leave the company and the associated impact on the company's cash flows.

Page 46

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

83. What are some things to watch out for when doing multiples analysis? Ans: While doing a multiples analysis, one needs to be aware of certain issues. · · · · · ·

When using multiples of publicly held firms to value one that is not, one should be aware of the presence of a marketability discount that can be sizable. Identifying one or more comparable firms is not an easy task. When using the multiple of a comparable firm, one needs to be aware of differences in the capital structures of the firms being compared. You are estimating a fair market value, not the investment value. It is important to make sure that the numerator and the denominator of the ratio you are using are consistent with each other. The data used to compute the multiple for the comparable company should include the stock price as of the valuation date and accounting data from the same period for which you have accounting data for the company of interest.

Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

84. Why does the value of a business change over time? Ans: The value of a business changes over time because of: • changes in general economic conditions, industry conditions, and managers' decisions all affect the value of the cash flows that a business is expected to generate in the future. • actions by competitors also affect the value of a business. • the investment, operating, and financing decisions made by managers also affect the value of a business.

Page 47

Fundamentals of Corporate Finance 3e

Test Bank

Chapter 19: Financial Planning and Managing Growth Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 1. Financial planning deals with establishing sales forecasts for a time horizon set by a firm's management. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 2. In putting together a financial plan, management addresses three main issues through their strategic plan, investment plan, and financing plan. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 3. The investment plan of a firm addresses the issue of what capital resources the management needs to get to achieve its goals. A) True B) False Ans: A

19-1

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 4. The financing plan deals with how a firm is going to secure the funds needed to pay for the capital resources required. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 5. The financing plan documents a firm's long-term goals, the strategies that management will use to achieve the goals, and the capabilities that the firm needs to sustain its competitive position. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 6. The strategic plan identifies major areas for investments in productive assets, and also identifies mergers, alliances, and divestitures to strengthen a firm’s business portfolio. A) True B) False Ans: A

19-2

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 7. The strategic plan of a firm addresses the issue of what capital resources the management needs to achieve its goals. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 8. Capital expenditures can be one-time investments or routine investments that allow a firm to continue its operations. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 9. Once capital investments are made, they are almost impossible to be reversed. A) True B) False Ans: A

19-3

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 10. In the financing plan of a firm, management states that the firm will seek to raise funds externally even if sufficient internally generated funds are available to fund projects. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 11. The financial plan focuses only on strategic planning and investment planning. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 12. The cash budget identifying the time line for cash inflows and outflows included in divisional business plans is a part of the financial plan. A) True B) False Ans: A

19-4

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 13. Financial planning helps management to establish financial and operating goals for a firm and to communicate those goals throughout the firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 14. Financial planning models are not considered an integral part of financial planning. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 15. Financial models provide management with the ability to prepare projected financial statements. A) True B) False Ans: A

19-5

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 16. Sales are often correlated to the regional or national economy, and hence economic forecasts are incorporated into the financial planning model. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 17. Financial statements and sales forecasts are considered major inputs in developing financial planning models. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 18. Investment and financing policy decisions are not considered inputs in financial planning models. A) True B) False Ans: B

19-6

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 19. The outputs of the financial planning model are a series of pro forma financial statements and financial ratios based on these statements. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Budget Preparation AICPA: Industry/Sector Perspective 20. Pro forma financial statements that result from financial planning models are always perfectly balanced. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Budget Preparation AICPA: Industry/Sector Perspective 21. Projected or pro forma statements can be used to analyze the investment alternatives but not to estimate the amounts of external funding needed. A) True B) False Ans: B

19-7

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 22. Sales are often correlated to the regional or national economy, so it is not necessary to incorporate economic forecasts into the model. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 23. The percent of sales model is a complex financial planning model. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 24. In the percent of sales model, all income statement and balance sheet accounts vary directly with sales. A) True B) False Ans: B

19-8

Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 25. The capital intensity ratio measures the dollar amount of sales per dollar invested in assets. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 26. Fixed assets vary directly with sales when firms are operating at less than full capacity. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 27. Firms that are not highly capital intensive tend to be more risky than similar firms that use less fixed assets. A) True B) False Ans: B

19-9

Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 28. In cases where fixed assets are added as large discrete units, and much of a firm’s capacity may not be utilized for some period of time. These types of assets are called lumpy assets. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 29. When a firm maintains a constant dividend policy, the firm's growth rate has no bearing on the external financing needed. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 30. Holding the growth rate constant, the higher a firm's dividend payout ratio, the larger the amount of external debt or equity financing needed. A) True B) False Ans: A

19-10

Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 31. The sustainable growth rate is the rate of growth that a firm can sustain without selling additional debt. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 32. The sustainable growth rate is the rate of growth that a firm can sustain without selling additional equity while maintaining the same capital structure. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 33. The higher a firm's dividend payout ratio, the higher is the firm's internal growth rate. A) True B) False Ans: B

19-11

Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 34. The higher a firm's plowback ratio, the higher is its sustainable growth rate. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 35. The lower a firm's ROE, the lower is the firm's sustainable growth rate. A) True B) False Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 36. Which of the following components make up a financial plan? A) The strategic plan B) The investment plan C) The financing plan D) All of these Ans: D

19-12

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 37. Which of the following issues is addressed in a financial plan? A) Where is the company headed? B) What capital resources does the management need to get there? C) How is the firm going to pay for the resources needed? D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 38. Which of the following issues is NOT addressed in a firm’s financial plan? A) What is the growth rate for the firm's main competitor? B) Where is the firm headed? C) What capital resources does the management need to get there? D) How is the firm going to pay for the resources needed? Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 39. The strategic plan identifies A) the lines of business in which a firm will compete. B) major areas of investment in productive assets. C) capital expenditures, acquisitions, and new lines of business. D) All of these Ans: D

19-13

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 40. The strategic plan does NOT identify A) major areas of investment in productive assets. B) future mergers, alliances, and divestitures. C) working capital strategies. D) the lines of business a firm will compete. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 41. Which of the following is true of capital expenditures? A) It is part of a firm's investment plan. B) Once a capital investment is made, it is almost always impossible to be reversed. C) Capital expenditures can be one-time investments or routine investments that allow a firm to continue its operations. D) All of these Ans: D

19-14

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 42. The financing plan of a firm will indicate A) the dollar amount of funds that has to be raised externally and the sources of funds available to the firm, the desired capital structure for the firm, and the firm's dividend policy. B) the dollar amount of funds that has to be raised externally and the sources of funds available to the firm, the desired capital structure for the firm, and the firm's working capital policy. C) the dollar amount of funds that has to be raised externally and the sources of funds available to the firm, the firm's dividend policy, and the firm's working capital policy. D) the firm's dividend policy, the desired capital structure for the firm, and the firm's working capital policy. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 43. Which of the following is a part of a financing plan? A) The dollar amount of funds that has to be raised externally and the sources of funds available to a firm B) The desired capital structure for a firm C) A firm's dividend policy D) All of these Ans: D

19-15

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 44. A financial plan includes A) the strategic plan, financing plan, and options plan. B) the strategic plan, investment plan, and financing plan. C) the financing plan, investment plan, and options plan. D) None of these Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 45. The financial planning model focuses on A) the inventory accounting method decision and the accounts payables decision. B) the current assets decision and the current liabilities decision. C) the investment decision and the financing decision. D) None of these Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 46. Financial planning models A) help management make investment decisions. B) help management make financing decisions. C) make the analysis faster and accurate. D) All of these Ans: D

19-16

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 47. The sales forecasts used in financial planning A) are developed using a variety of techniques. B) are generated within the firm. C) utilize macroeconomic variables as input. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 48. Which of the following statements is NOT true? A) Sales forecasts models are typically very basic and use no complicated analysis. B) Sales forecasts are generated within a firm. C) Sales forecasts utilize economic variables as input. D) All of these Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 49. The inputs used in building financial planning models include A) financial statements, sales forecasts, and a firm's investment and financial policy decisions. B) pro forma statements, sales forecasts, and macroeconomic variables. C) pro forma statements, sales forecasts, and financing decisions. D) None of these Ans: A

19-17

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 50. Which of the following is NOT an input in financial planning models? A) Financial statements B) Pro forma financial statements C) Investment decisions D) Financing decisions Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 51. Which of the following statements is NOT true about financial planning models? A) Financial statements serve as the first major input and become the baseline to compare the projected financial statements. B) Economic forecasts and their impact on the firm's sales are also included in financial planning models. C) Investment and financing decisions are not considered as inputs in financial planning models. D) Changes in a firm's balance sheet and income statement items as a result of the growth in sales are also used in these models. Ans: C

19-18

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 52. Planning models that are more sophisticated than the percent of sales method have A) all variable costs change directly with sales. B) working capital accounts like inventory, accounts receivables, and accounts payables vary directly with sales. C) fixed assets that do not always vary directly with sales. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 53. Which of the following statements is NOT true about more sophisticated financial planning model? A) Only fixed costs change directly with sales. B) Working capital accounts like inventory, accounts receivables, and accounts payables vary directly with sales. C) Fixed assets do not always vary directly with sales. D) All of these Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 54. As sales increase, a firm needs to _____ proportionately to support the _____. A) increase the level of fixed assets; increase the level of inventory B) increase the level of inventory; higher sales level C) increase the level of inventory; increase the level of fixed assets D) None of these Ans: B

19-19

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 55. Which of the following statements is NOT true for a firm that operates below full capacity? A) Fixed assets can vary directly with sales. B) Fixed assets will not vary directly with sales. C) Fixed assets per unit can be incrementally changed. D) All of these Ans: A

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 56. Which of the following statements is NOT true? A) The ratio of total assets to sales is called the capital intensity ratio. B) The ratio of sales to total equity is called the capital intensity ratio. C) The higher the capital intensity ratio, the more capital a firm needs to generate sales. D) Firms that have high capital intensive ratios are riskier than similar firms that use less fixed assets. Ans B :

19-20

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 57. A firm paid out $163,961.60 as dividends on net income of $298,112. What is the firm's retention ratio? A) 55% B) 45% C) 50% D) None of these Ans: B Feedback: Dividends = $163,961.60 Net income = $298,112.

Dividend payout ratio =

Dividends $163,961.60 = = 55% Net income $298,112.00

19-21

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 58. Drekker, Inc. has revenues of $312,766, costs of $220,222, interest payment of $31,477, and a tax rate of 34 percent. It paid dividends of $34,125 to shareholders. Find the firm's dividend payout ratio and retention ratio. (Round your percentage answers to nearest whole number.) A) 85%, 15% B) 45%, 55% C) 55%, 45% D) 15%, 85% Ans: A Feedback: Revenues $312,766.00 Costs 220,222.00 EBIT $92,544.00 Interest 31,477.00 EBT $61,067.00 Taxes (34%) 20,762.78 Net income $40,304.22 Dividends paid = $34,125

Dividend payout ratio =

Dividends Net Income

34,125.00

85%

40,304.22

19-22

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 59. Comacho Traders has total assets of $513,480 and sales of $723,062. What is the firm's capital intensity ratio? (Round to two decimal places.) A) 1.41 B) 0.71 C) 1.23 D) None of these Ans: B Feedback: Total assets = $513,480 Sales = $723,062

Total assets Net sales $513, 480 = = 71.01% $723, 062 =0.71

Capital intensity ratio =

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 60. Michael Holdings, Inc. has total assets of $1,480,072 and sales of $2,236,625. What is the firm's capital intensity ratio? (Round to two decimal places.) A) 66.17% B) 53.73% C) 151.14% D) None of these Ans: A Feedback: Total assets = $1,480,072 Sales = $2,236,625

Total assets Net sales $1, 480, 072 = = 66.17% $2, 236, 625

Capital intensity ratio =

19-23

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level Of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 61. Dennis Compton, Inc. has total assets of $5,335,901 and a capital intensity of 53.9%. What is the firm's sales? (Round to nearest whole dollar.) A) $5,335,901 B) $2,828,028 C) $9,899,631 D) None of these Ans: C Feedback: Total assets = $5,335,901 Capital intensity ratio = 53.9%

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 62. Which of the following statements in using more sophisticated planning models is NOT true? A) Current liabilities are likely to vary directly with sales. B) Long-term liabilities and equity accounts change as a direct result of managerial decisions. C) Retained earnings will vary directly as sales changes. D) All of these Ans: C

19-24

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 63. Which of the following statements in using more sophisticated planning models is true? A) Current liabilities are likely to vary directly with sales. B) Long-term liabilities and equity accounts change as a direct result of managerial decisions. C) Retained earnings will vary as sales changes but not directly as it is affected by the firm's dividend payout policy. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 64. Which of the following includes weaknesses in financial planning models? A) Interest expense is not accounted. B) All working capital accounts do not necessarily vary directly with sales, especially cash and inventory. C) The way fixed assets are handled as lumpy assets, leaving the company with excess capacity. D) All of these Ans: D

19-25

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 65. Which of the following statements in accounting for changes in fixed assets is NOT true? A) When a firm is not operating at full capacity, sales may be increased without adding any new fixed assets. B) Since it requires time to get new assets operational, they are added in small discrete quantities. C) Fixed assets are added in large discrete units called lumpy assets. D) All of these Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 66. Which of the following statements in accounting for changes in fixed assets is NOT true? A) When a firm is not operating at full capacity, sales may be decreased without adding any new fixed assets. B) Since it requires time to get new assets operational, they are added as the firm nears full capacity. C) Fixed assets are added in large discrete units called lumpy assets. D) All of these Ans: D

19-26

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 67. Which of the following is true about the capital budgeting process? A) Management identifies a list of potential projects that are consistent with the business strategy and ranks them according to the value they would create for the shareholders. B) Rapid growth is considered a desirable achievement in capital budgeting decisions. C) The cost of the projects should comply with the firm's budget constraints. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 68. Which of the following is NOT true about the capital budgeting process? A) Management identifies a list of potential projects that are consistent with the business strategy and ranks them according to the value they would create for the shareholders. B) Rapid growth is considered a desirable achievement in capital budgeting decisions. C) Once the list is made, no management review can change it. D) All of these Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 69. External funding needed (EFN) is A) the additional debt or equity a firm needs to issue so that it can purchase additional assets to support an increase in sales. B) the additional funds raised by a firm to pay off existing short-term debt. C) the additional funds raised by a firm to pay off existing long-term debt. D) None of these Ans: A

19-27

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 70. Which of the following statements is NOT true? A) The internal growth rate (IGR) is defined as the maximum growth rate that a firm can achieve without external financing. B) The higher the retained earnings generated by a firm, the higher the growth possible without using external funding. C) Given the same level of retained earnings, a firm that has the higher amount of total assets has a higher growth possibility without using external funding. D) All of these Ans: C

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 71. Firms that achieve higher growth rates without seeking external financing A) have a high plowback ratio. B) have less equity and/or are able to generate high net income leading to a high ROE. C) are not highly leveraged. D) All of these Ans: D

19-28

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 72. Firms that achieve higher growth rates without seeking external financing A) have a low plowback ratio. B) have less equity and/or are able to generate high net income leading to a high ROE. C) are highly leveraged. D) None of these Ans: B

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 73. The sustainable growth rate (SGR) A) is a function of the plowback ratio and the ROE. B) the rate of growth that a firm can sustain without selling additional shares of equity. C) helps management to determine whether they can avoid issuing new equity. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 74. Which of the following statements about the sustainable growth rate (SGR) is NOT true? A) The SGR is a function of the plowback ratio and the ROE. B) The SGR determines the rate of growth that a firm can sustain without selling additional shares of equity. C) The SGR helps management to determine whether they can avoid issuing new debt. D) All of these Ans: C

19-29

Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 75. Which of the following statements about the sustainable growth rate (SGR) is true? A) The higher a firm's ROE, the higher the SGR. B) The higher the plowback ratio, the larger the proportion of net income retained in the firm and the greater the firm's SGR. C) Both A and B are true statements. D) None of these are true Ans: C

Format: Multiple Choice Learning Objective: LO 3, 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 76. Hilton Corp. has revenues of $1,214,800, costs of $816,355, and pays a tax rate of 32 percent. If the firm pays out 50 percent of its earnings as dividends every year, what is the amount of retained earnings? A) $135,471.30 B) $270,942.60 C) $413,032.00 D) None of these Ans: A Feedback: Revenue = $1,214,800 Costs = $816,355; Tax rate = 32% Payout ratio = 50% Retained earnings = $270,942.60 (1

0.50) = $135,471.30

19-30

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3, 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 77. Tangent Inc. has revenues of $4,375,233, costs of $2,467,321, and pays a tax rate of 34 percent. If the firm pays out 60 percent of its earnings as dividends every year, what is the amount of retained earnings? (Round final answer to two decimal places.) A) $171,254.18 B) $755,533.15 C) $503,688.77 D) None of these Ans: C Feedback: Revenue = $4,375,233 Costs = $2,467,321; Tax rate = 34% Payout ratio = 60% Retained earnings = $1,259,221.92 (1 − 0.60) = $503,688.77

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3, 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 78. Tradewinds Corp. has revenues of $9,651,220, costs of $6,080,412, interest payment of $511,233, and a tax rate of 34 percent. It paid dividends of $1,384,125 to shareholders. Find the firm's dividend payout ratio and retention ratio.(Round the percentage answer to nearest whole number.) A) 66%, 34% B) 25%, 75% C) 69%, 31% D) 34%, 66% Ans: C Feedback: Revenues $9,651,220.00 Costs 6,080,412.00 EBIT $3,570,808.00 Interest 511,233.00 EBT $3,059,575.00 Taxes (34%) 1,040,255.50 Net income $2,019,319.50 Dividends paid = $1,384,125

Dividend payout ratio =

Dividends $1,384,125.00 = = 68.5% Net income $2, 019,319.50 =69%

19-32

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 79. Swan Supply Company has net income of $1,212,335 on assets of $12,522,788 and retains 70 percent of its income every year. What is the company's internal growth rate? (Do not round intermediate calculations. Round final answer to one decimal place.) A) 7.6% B) 6.8% C) 8.6% D) 9.3% Ans: B Feedback: Net income = $1,212,335 Total assets = $12,522,788 Plowback ratio = 70%

Internal growth rate (IGR) = Plowback ratio  ROE  Equity ratio Net income Equity = Plowback ratio   Equity Total assets Net income = Plowback ratio  Total assets $1, 212,335 = 0.70  $12,522, 788 = 6.8%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 80. Mercantile Co. has net income of $3,413,500 on assets of $16,109,445 and retains 55 percent of its income every year. What is the company's internal growth rate? (Do not round intermediate calculations. Round final answer to two decimal places.) A) 21.21% B) 8.62% C) 11.65% D) 9.43% Ans: C Feedback: Net income = $3,413,500 Total assets = $16,109,445 Plowback ratio = 55%

Internal growth rate (IGR) = Plowback ratio  ROE  Equity ratio Net income Equity = Plowback ratio   Equity Total assets Net income = Plowback ratio  Total assets $3, 413,500 = 0.55  $16,109, 445 = 11.65%

19-34

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 81. Mandolin Bottlers Co. has net income of $4,272,335 and retains 65 percent of its income every year. If the company's internal growth rate is 8.6 percent, what is the firm’s total assets? (Round your answer to the nearest dollar.) A) $32,290,904 B) $238,824 C) $30,388,235 D) None of these Ans: A Feedback: Net income = $4,272,335 Total assets =? Plowback ratio = 65% IGR = 8.6%

Internal growth rate (IGR) = Plowback ratio  ROE  Equity ratio Net income Equity = Plowback ratio   Equity Total assets Net income = Plowback ratio  Total assets $4, 272,335 0.086 = 0.65  Total assets $4,272,335 Total assets = 0.65  = $32, 290, 904 0.086

19-35

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 82. Meredith Inc. has a return on equity of 21.5 percent, an equity ratio of 55 percent, and a dividend payout ratio of 70 percent. What is the company's internal growth rate? (Round to two decimal places) A) 8.32% B) 3.55% C) 6.43% D) 4.84% Ans: B Feedback: ROE = 21.5% Equity ratio = 55% Dividend payout ratio = 70% Plowback ratio = 30%

IGR = Plowback ratio  ROE  Equity ratio = 0.30  0.215  0.55 = 3.55%

19-36

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 83. Sterling Resorts Co. has total assets worth $13,442,975. It is expecting to grow its revenue at a rate of 25 percent next year. For next year, it expects a net income of $3,475,321 and will pay out 45 percent as dividends. What is the external financing needed by the firm to meet its growth expectations? A) $1,796,849.30 B) $1,449,317.20 C) No external funding is needed. D) None of these Ans: B Feedback: Total assets = $13,442,975 Expected net income = $ 3,475,321 Addition to retained earnings = $3,475,321 × (1 − 0.45) = $1,911,426.55

19-37

Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 84. Nederland Finance Company has total assets worth $9,751,223. It is expecting to grow its revenue at a rate of 20 percent next year and will have a net income of $2,213,564 next year. The firm pays out 65 percent of its net income as dividends. What is the external financing needed by this firm to meet its growth expectations? A) $1,175,497.20 B) $511,428.00 C) No external funding is needed. D) None of these Ans: A Feedback: Total assets = $9,751,223 Net income = $2,213,564 Addition to retained earnings = $2,213,564 × (1 − 0.65) = $774,747.40

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 85. Triumph Company has total assets worth $6,413,228. Next year it expects a net income of $3,145,778 and will pay out 70 percent as dividends. If the firm wants to limit its external financing to $1 million, what is the growth rate it can support? (Round your final answer to one decimal place.) A) 32.9% B) 6.4% C) 30.3% D) 26.5% Ans: C Feedback: Total assets = $6,413,228 Net income = $3,145,778 EFN = $1,000,000 Addition to retained earnings = $3,145,778 × (1 − 0.70) = $943,733.40

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 86. Jockey Company has total assets worth $4,417,665. At year-end, it will have net income of $2,771,342 and pay out 60 percent as dividends. If the firm wants no external financing, what is the growth rate it can support? (Round your final answer to one decimal place) A) 32.9% B) 25.1% C) 30.3% D) 27.3% Ans: B Feedback: Total assets = $4,417,665 Net income = $2,771,342 EFN = $0 Addition to retained earnings = $2,771,342 × (1 – 0.60) = $1,108,536.80

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 87. If Newell Corp. has a ROE of 18.6 percent and a dividend payout ratio of 60 percent, what is its sustainable growth rate? A) 7.44% B) 2.15% C) 0.47% D) 8.2% Ans: A Feedback: ROE = 18.6% Payout Ratio = 60%

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 88. If Merton Corp. has a ROE of 23.4 percent, what is the plowback ratio needed to achieve a sustainable growth rate of 7 percent? (Round to nearest whole number.) A) 34% B) 30% C) 24% D) 28% Ans: B Feedback: ROE = 23.4% Plowback ratio =? Sustainable growth rate = 7%

=30%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 89. Sterling Inc. currently has sales of $4,512,644 and net income of $736,253. It has a debt ratio of 47 percent and a dividend payout ratio of 65 percent. The company has total assets of $3,812,832. What is the company's sustainable growth rate? (In your interim computations, round your ROE percentage to one decimal place.) A) 12.74% B) 23.72% C) 18.96% D) 20.10% Ans: A Feedback: Sales = $4,512,644 Net income = $736,253 Debt ratio = 47% Dividend payout ratio = 65% Total assets = $3,812,832

Equity = 0.53 × $3,812,832 = $2,020,800.96

SGR = Plowback ratio  ROE = 0.35  0.364 = 12.74%

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 90. Courtney Bike, Co. has a net profit margin of 7.8 percent, a debt ratio of 45 percent, total assets of $2,112,370, and sales of $4,276,990. If the company has a dividend payout ratio of 60 percent, what is the company's sustainable growth rate? (Do not round intermediate calculations. Round final answer to one decimal place.) A) 17.2% B) 15.6% C) 11.5% D) 18.9% Ans: C Feedback: Net profit margin = 7.8% Debt ratio = 45% Total assets = $2,112,370 Sales = $4,276,990 Dividend payout ratio = 60%

Net income  Plowback ratio Equity $333,605.22 =  0.40 $1,161,803.50 = 11.49%

SGR =

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective 91. Explain how the strategic plan, investment plan, and financing plan integrate to help management do financial planning. Ans: Financial planning involves planning over a three to five year horizon. It calls for the integration of three basic plans—the strategic plan, the investment plan, and the financing plan. The strategic plan documents a firm's long-term goals, the strategies that management will use to achieve the goals, and the capabilities the firm needs to sustain its competitive position. The planning is done by the firm's top management with the financial manager providing key input, and it has to be approved by the board of directors. The strategic plan identifies the line of business in which the firm will compete, major areas of investment in real assets, and capital expenditures among other things. Next, the investment plan, which includes the capital budget, describes the firm's outlay for plant and equipment. Management will identify a list of potential projects that are consistent with the business strategy and rank them according to value they would create for the shareholders. Senior management then will review the list before revising it in order to comply with the firm's budget constraints. Based on the list prepared in the capital budget, management now needs to decide how to fund the projects. The firm will try and use a blend of internally generated funds and externally raised funds to finance the capital expenditures. Depending on the level of internally generated funds available to the firm, the firm will seek to raise funds in the form of either debt or equity.

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 92. Discuss the implications of the internal growth rate. Ans: The internal growth rate (IGR) is the maximum growth rate a firm can sustain without having to raise any finance from external sources. Firms that are small and growing typically have limited access to outside financing. Such firms have a high enough retention ratio to fund growth, generate a high level of net income for every dollar of equity, and use low amounts of leverage or debt financing. Once a firm reaches a certain size and growth rate, it may be unable to totally fund their growth with retained earnings alone and may have to enter the capital markets to raise funds.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: FSA AICPA: Industry/Sector Perspective 93. Explain the sustainable growth rate and discuss what it means to a firm's management. Ans: The sustainable growth rate (SGR) is the maximum growth rate at which a firm can grow without needing any external equity financing and holding the level of debt constant. Growing a firm at the sustainable growth rate allows management to avoid costly equity issues, thus reducing the dilution of earnings. Whenever a firm grows faster than the SGR, the firm is going to need external financing and may have to resort to debt financing, which increases the company's risk.

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Fundamentals of Corporate Finance 3e

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Chapter 20: Options and Corporate Finance

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

1. A put option with a strike price of $20 is expiring today. The stock is currently selling at $25. Based on this information, the put option should not be exercised. A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

2. A stock is selling for $50 today. A call option on the stock with a strike price of $50 is set to expire next month. If the price of the stock goes down tomorrow we would expect the price of the call option to go down as well. A) True B) False Ans: A Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

3. A call option can sometimes be priced higher than the underlying asset. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

4. Neither a call nor a put option can have a negative price. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

5. The current price of an asset is $75. A put option on the asset with a strike price of $100 expires one year from now. It is possible, without arbitrage, for this put option to be priced at $24 today. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

6. If the risk-free rate of interest increases, all else being equal, we would expect the value of a call option to increase. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

7. In the binomial pricing model, an option is priced using a replicating portfolio that typically consists of a risk-free bond and the asset underlying the option. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

8. To price an option using the binomial pricing model, it is important that we know the probability that the asset will increase in value. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

9. When using the binomial pricing model to price an option, the volatility of the value of the underlying asset is represented by the difference between the two possible future values of the underlying asset. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

10. Consider a call option on a stock with a strike price of $60. If the stock price at expiration is $50, the payoff from the call option is $10. A) True B) False Ans: B Feedback: Call option will not be exercised as the stock price is lower than the strike price. Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

11. Consider a put option on a stock with a strike price of $60. If the stock price at expiration is $50, the payoff from the put option is $10. A) True B) False Ans: A Feedback: Put option will be exercised as the stock price is lower than the strike price. Payoff = $60 – $50 Payoff = $10

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

12. Suppose you have sold a put option on a stock with a strike price of $25 and assume the current price of the stock is $25. If the stock price at expiration is $30, your payoff will be –$5. A) True B) False Ans: B Feedback: The value of put option to the owner is $0 when the value of underlying asset is greater than or equal to the strike price. Since the stock price at expiration is $30 which is greater than the strike price of $25. The payoff value would be equal to $0. Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

13. A portfolio consisting of one put option and one call option, both with the same exercise price is a good investment strategy for investors who don't know whether an asset's value is likely to go up or down, but think that the volatility of the asset will increase. A) True B) False Ans: A Format: True/False Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

14. If a firm adds financial options to its debt securities, it will increase the interest expense to the firm. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

15. If a project has a positive NPV, then the real options that affect the project are not important to estimating the value of the project. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

16. The option to defer investment can be characterized as the flexibility to wait and learn more information about a project before committing resources to the project. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

17. The management’s ability to choose to terminate a project is like a put option. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

18. After taking into account the value of real options, it is possible that some projects with a negative NPV should be pursued. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

19. A company is negotiating for the option to develop a platinum mine. Under the terms of the option contract, the company would be able to purchase the development rights to the mine one year from now for an exercise price specified today. If, during the negotiations over the option contract, the volatility of the price of platinum increases, the company should expect to pay a higher price for the development option. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

20. The option to abandon a project can decrease its value. A) True B) False Ans: B

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Fundamentals of Corporate Finance 3e

Test Bank

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

21. Ecofren Thermostats Co. sells equipment to residential and commercial customers. It is considering whether or not to develop a new line of smart thermostats. The discounted cash flows from smart thermostat sales are not likely to cover the development costs. However, the company has decided to pursue the project anyway. If the commercial technology is successful, it might be applied to a new line of very profitable residential thermostats. This is an example of the option to make follow-on investments. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

22. Consider a firm with a single loan. There are no interest payments on the loan, but the principal and interest are all due in two years. It is uncertain whether the cash flow the company will produce will be enough to pay off the debt. The payoff to stockholders in this company resembles a call option. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

23. Consider a company that is likely to go bankrupt in the next year. The bondholders may encourage the company to pursue risky negative-NPV projects in hopes that the firm will avoid financial distress. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

24. Consider a company that is likely to go bankrupt in the next year. Stockholders may wish to pursue negative-NPV projects, even if there is no additional value to the project from real options. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

25. By designing compensation plans with performance bonuses, stock-based compensation, and stock options, corporate boards are attempting to make the payoff function for managers look similar to the payoff function for stockholders. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

26. Financial options can be used to hedge risks such as interest rates and foreign exchange rates. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

27. Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20 and an expiration date at the end of the season is selling for $1,000, the farmer can purchase the put option to guarantee she gets $19 a bushel. A) True B) False Ans: A Feedback: Put option will guarantee $20,000 minus the put option premium of $1,000 She will get $19,000 for 1,000 bushels or $19 per bushel

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

28. Suppose the current spot price of corn is $20 a bushel. A corn farmer expects to produce 2,000 bushels at the end of the season, and she wants to ensure that she gets at least $18 per bushel. Call options on 1,000 bushels of corn with a strike price of $15 and an expiration date at the end of the season are selling for $3,000. By selling call options on her corn crop, the farmer can guarantee that she gets at least $18 per bushel. A) True B) False Ans: B

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

29. Hedging is the process of using financial instruments such as options, forwards, futures, and swaps to reduce the financial risks faced by a firm. A) True B) False Ans: A

Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

30. Harmostrax Co. has a defined-benefit pension plan for its employees. To fund the plan, the company makes periodic contributions to a stock investment fund. If the stock market declines significantly, the company would have to make additional contributions to make up for lost revenue. The company could hedge its risk of a market downturn by periodically purchasing put options on the stock market. A) True B) False Ans: A

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Fundamentals of Corporate Finance 3e

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Format: True/False Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

31. A small soybean farmer wants to hedge the price risk of his next crop, but he is financially constrained. He can't raise capital by either borrowing money or selling his current assets. Instead, he sells call options on his soybean crop with a strike price of $14 per bushel at a premium of $0.50 a bushel. Using the proceeds from selling the call options, he buys put options on his soybean crop with a strike price of $11.00 per bushel at a premium of $0.35 per bushel. Assume the risk-free interest rate is 0 percent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel. A) True B) False Ans: A Feedback: Call option premium earned = $0.50 Put option premium paid = $0.35 Net premium earned= $0.15 If price of crop at expiry falls below $11, the farmer would exercise put option. If price of crop at expiry exceeds $14, the farmer is obligated to sell the crop at $14. Range = (Minimum price + Net premium earned) to (Maximum price + Net premium earned) Range = ($11 + $0.15) to ($14 + $0.15) Range = $11.15 to $14.15

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

32. An investor (the buyer) purchases a call option from a seller. On the expiration date of a call option: A) the buyer has the obligation to buy the underlying asset and the seller has the obligation to sell it. B) the buyer has the right to buy the underlying asset and the seller has the obligation to sell it. C) the buyer has the obligation to sell the underlying asset and the seller has the right to buy it. D) the buyer has the right to sell the underlying asset and the seller has the right to buy it. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

33. An investor (the buyer) purchases a put option from a seller. On the expiration date of a put option: A) the buyer has the obligation to sell the underlying asset and the seller has the right to buy it. B) the buyer has the obligation to sell the underlying asset and the seller has the obligation to buy it. C) the buyer has the right to sell the underlying asset and the seller has the obligation to buy it. D) the buyer has the right to buy the underlying asset and the seller has the right to sell it. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

34. Which of the following statements is true of a call option? A) The value of a call option can never be positive. B) The value of a call option can be more than the value of the underlying asset. C) The value of a call option can never be worth less than the current value of the asset minus present value of the strike price. D) The value of a call option can be worth more than the strike price. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

35. Which of the following statements is true of a put option? A) The value of a put option can be negative. B) The value of a put option can be worth more than the underlying asset. C) The value of a put option can be less than the present value of the strike price minus the current value of the underlying asset. D) The value of a put option increases when the stock price increases. Ans: B

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

36. Suppose you own a call option on a stock with a strike price of $20 that expires today. The price of the underlying stock is $15. If you exercise the option and immediately sell the stock: A) you will earn $5. B) you will lose $5. C) you will lose $15. D) you will earn $15. Ans: B Feedback: Payoff for call option = Stock price – Strike price = $15 – $20 = –$5 Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

37. Suppose you own a put option on a stock with a strike price of $35 that expires today. The price of the underlying stock is $25. If you purchase the stock and exercise the put option: A) you will earn $10. B) you will lose $10. C) you will earn $25. D) you will lose $25. Ans: A Feedback: Payoff for put option = Strike price – Stock price = $35 – $25 = $10

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

38. Consider an option that gives the owner the right to buy a stock for $20 only on the third Friday of May, next year. The option being described is: A) an American call option. B) a European put option. C) an American put option. D) a European call option. Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

39. Consider an American and a European call option on a dividend-paying stock, with otherwise identical features (same strike price, etc.). Which of the following statements is true? A) The American call option will never be worth less than the European call option. B) The European call option will never be worth less than the American call option. C) Both European call and American call option should always have the same value. D) The American option can be exercised only on specific dates during the life of the option. Ans: A

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

40. The option payoff function is the relationship: A) between the value of an option and the value of a firm. B) between the value of an option and the price of the underlying asset. C) between the call premium and the value of an option. D) between the call premium and the price of underlying asset. Ans: B

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

41. Which of the following changes, when considered individually, will increase the value of a call option? A) The value of the underlying asset becomes more volatile B) The price of the underlying asset goes down C) Getting closer to the expiration date (the passage of time) D) A higher strike price Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

42. Which of the following changes, when considered individually, will increase the value of a put option? A) An increase in the risk-free interest rate B) Lower volatility of the price of the underlying asset C) A higher strike price D) The option is nearing its expiration date. Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

43. What happens to the value of call and put options if the volatility of the price of underlying asset decreases? A) Put options will be worth more, call options will be worth less. B) Put options will be worth less, call options will be worth more. C) Both call and put options will be worth more. D) Both call and put options will be worth less. Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

44. If the price of the underlying asset increases, what happens to the value of call and put options? A) Put options will be worth more, call options will be worth less. B) Put options will be worth less, call options will be worth more. C) Both call and put options will be worth more. D) Both call and put options will be worth less. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

45. With everything else constant, as the expiration date gets closer, what happens to the value of call and put options? A) Call option will be worth more, put options will be worth less. B) Call option will be worth less, put options will be worth more. C) Both call and put options will be worth more. D) Both call and put options will be worth less. Ans: D

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

46. With everything else held constant, what happens to the value of call and put options if the risk-free interest rate increases? A) Call options will be worth more, put options will be worth less. B) Call options will be worth less, put options will be worth more. C) Both call and put options will be worth less. D) Both call and put options will be worth more. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

47. The management at PhoneUn considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to be easily converted to manufacture other types of large machinery. If its new line of cars is poorly received, its plant should be easy to sell to another manufacturing company. In this example, the price at which they expect to sell the plant if things go poorly resembles: A) the premium of a put option on the plant. B) the premium of a call option on the plant. C) the strike price of a put option on the plant. D) the strike price of a call option the plant. Ans: C

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

48. Frost1 Motors is very likely to enter financial distress. Without a dramatic change of events over the next couple of years, the company will be unable to pay its lenders, who will then gain control of the company's assets. A group of stockholders has pressured the company's management to begin manufacturing and selling one of the company's concept cars in the hope that it will be a big hit. Concept cars are prototypes that are developed to test new ideas and to show off at auto shows. Although elements of concept cars are often incorporated into product lines, rushing a concept car into production is very risky. The best estimates about the concept car make it appear to be a negative-NPV project. This is a good example of: A) the dividend payout problem. B) the underinvestment problem. C) the asset substitution problem. D) the agency cost of equity. Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

49. Why would the managers of a firm bundle options with stock in an IPO? A) To increase the supply of outstanding shares in order to attract more investors B) To promote the dilution of common stockholders’ control on assets C) To reduce the number of common shares that must be sold at the IPO price in order to raise the amount of money that the firm needs D) To bring down the earnings per share of common stockholders Ans: C

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

50. When a company issues convertible bonds with a $1,000 par value that can be converted to 20 shares of common stock, each bond includes: A) a put option with an exercise price of $200 per share. B) a call option with an exercise price of $50 per share. C) a put option with an exercise price of $20 per share. D) a call option with an exercise price of $20 per share Ans: B Feedback: The bond includes call option Exercise price = Par value of convertible bonds / Number of shares offered for conversion Exercise price = $1,000 / 20 shares = $50 per share.

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

51. Consider a CEO who holds neither stock nor stock options in the company she runs. Her payoff function regarding the firm's performance is most likely to resemble: A) stockholders. B) lenders. C) owners of a call option on the firm. D) holders of a risk-free bond with coupon payments equal to her salary. Ans: B

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

52. When the value of the firm is above the face value of the debt: A) the stockholders repay the debt and the equity is worth less than $0. B) the stockholders repay the debt and the equity is worth the difference between the firm value and the face value of the debt. C) the stockholders default and the lenders receive the value of the firm. D) the stockholders default and the equity is worth $0. Ans: B

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

53. Which of the following is a valid reason for managers selecting projects with negative NPV? A) The NPV analysis includes a valuable real option to expand the project if things go well. B) If a firm has debt, managers may create value for shareholders by taking on some risky negative NPV projects. C) Managers' payoff functions represent the payoffs of lenders. By taking negative NPV projects, the managers can create value for lenders. D) Projects having negative NPV can have high internal rate of return. An B s:

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

54. As the manager of a sporting goods company, you are presented with a new golf project. An inventor has recently patented the design for a new golf club that makes playing golf much easier. Your company has made contact with the inventor, who is willing to sell the exclusive rights to the technology, but if you don't act fast he will sell the rights to a rival company. You are not certain whether the new golf club will become popular, but your analysts have completed a basic NPV analysis. Given the available information, the project has a positive NPV. However, you know there are several real options associated with the project, including the option to abandon the project and the option to make follow-on investments. Which of the following statements regarding the project is correct? A) Based on the NPV analysis, you should accept the project. The value of the project may be worth more than the NPV analysis but not less. B) Based on the NPV analysis, you should accept the project. The NPV analysis contains all the information about the value of the project. C) Based on the NPV analysis, you should reject the project. Without additional information about the value of the real options, there is no way to make a decision. D) Based on the NPV analysis, you should reject the project. The NPV analysis contains all the information about the value of the project. Ans: A

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

55. Arctic Inc. has built a highly interactive operating system for mobile and other electronic gadgets. The development cost to the company was high but the system was inexpensive to sustain and market. The NPV of this project was negative. However, in the coming years the company plans to launch mobile phones, portable audio and video devices. The decision of launching the operating system for mobile and other devices is an example of: A) option to defer investment. B) option to abandon a project. C) option to change operations. D) option to make follow-on investments. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

56. The employment contracts for professional athletes often contain options for either the player or the team. Consider one recent contract in Major League Baseball. The player's salary was guaranteed for the first couple of years. However, after several years, the team had the option to cancel the contract if the player became injured. If we think of each player as a project for the team, this option feature of the contract is best described as: A) the option to defer investment. B) the option to make follow-on investments. C) the option to change operations. D) the option to abandon projects. Ans: D

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

57. Adosonic Reality is considering the construction of a new development of condominiums in downtown Austin, Texas. The site for the new development is currently occupied by an office building owned by the city. The project's profitability will depend largely on the population increase in Austin over the next several years. Rather than buy the site, Adosonic Reality has entered into an agreement with the city to pay $200,000 for the right to purchase the site for $10 million two years from now. The real option embedded in this contract is best described as: A) the option to defer investment. B) the option to make follow-on investments. C) the option to change operations. D) the option to abandon projects. Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

58. Consider a new firm that is working on the first generation of long-awaited consumer jet packs. The project will take a tremendous amount of R&D expenditure. Even if the development is successful, manufacturing the first generation of jet packs is likely to be so expensive that only a selected few consumers will be able to afford them. The projected sales of the first generation of jet packs almost certainly won't cover the development and manufacturing costs—the project has a negative NPV. Which of these reasons would validate the firm's decision to pursue the jet pack project? A) If development is unsuccessful, it can abandon the project before spending money on manufacturing. B) If the project is successful, it may lead to a very profitable second project—a cheaper jet pack that will be a positive-NPV project. C) Because it is a high-tech firm, the cash flows generated by a project are not important to valuing the company. D) If development is successful, it allows managers to reach wide range of consumers. Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

59. A local city government has awarded a contract to sequentially build five new elementary schools over the next 10 years. The price for each school has been spelled out in the contract, but at the beginning of each year the city can cancel the order for the remaining schools. The city government is concerned that if the population of the town does not grow as expected it may not need all of the schools. What sort of financial option does the option to cancel the order resemble? A) Owning a call option on the value of the new schools B) Owning a put option on the value of the new schools C) Selling a call option on the value of the new schools D) Selling a put option on the value of the new schools Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

60. Purchasing a house is a somewhat complicated process. Typically, if the buyer's offer is accepted by the seller, the transaction will not be completed or “closed” for several weeks. During this time the buyer may gather more information about the house or research other houses in the area. Some home purchase contracts include an option fee. The buyer may pay the seller a few hundred dollars for the right to walk away from the contract prior to closing for any reason. This option fee is best described as: A) the option to defer investment. B) the option to make follow-on investments. C) the option to change operations. D) a put option on the house. Ans: A

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium 61. The management at Sevenglobe Motors considered the option to abandon when building their new manufacturing plant. The design of the plant allows it to easily be converted to manufacture other types of large machinery. If their new line of cars is poorly received, their plant should be easy to sell to another manufacturing company. In this example, the extra cost of building the plant in such a way that it can easily be converted for other uses resembles: A) the premium of a put option on the plant. B) the premium of a call option on the plant. C) the strike price of a put option on the plant. D) the strike price of a call option on the plant. Ans: A

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

62. Anonxy Foods has made the decision to invest in a new line of organic microwave dinners. The new line of dinners is a negative-NPV project; paying its suppliers to convert to organic practices will be expensive. However, the company will be in a good position to expand into more profitable lines of food if consumer demand for organic foods grows more than expected. The negative value of the organic dinner project most closely resembles: A) the premium of a put option on future organic projects. B) the premium of a call option on future organic projects. C) the strike price of a put option on future organic projects. D) the strike price of a call option on future organic projects. Ans: B

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Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

63. Bifive Homes, Inc., is a developer of planned residential communities. It has entered into an option contract with a land owner outside Austin, Texas. It will pay the land owner $100,000 for the option to buy the land in two years at a price of $20 million. During that time Bifive Homes will evaluate population and real estate trends in Austin. Its plan is to buy the land if real estate prices in Austin increase enough that developing the land would be worth more than the $20 million price. The $20 million purchase price resembles: A) the premium price of a put option on the land. B) the premium price of a call option on the land. C) the strike price of a put option on the land. D) the strike price of a call option on the land. Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

64. The claim stockholders hold on cash flows in a company with outstanding debt is often described as: A) a call option on the firm's assets. B) a put option on the firm's assets. C) an interest-free bond with the same value as the firm's assets. D) a put option on the firm's liabilities. Ans: A

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

65. Which of the following statements is an example of the agency cost of debt? A) ABC Co. shareholders pressure management to invest in very risky projects in hopes that one of the investments might pay off. The company is highly leveraged, so shareholders have little to lose. B) ABC Co. has no debt but very few investment opportunities. The board of directors decides not to pay out a large special dividend. Lenders collect 100 percent of the face value of the debt. C) ABC Co. is financially sound. The company has a negative-NPV investment opportunity. Investors refuse to invest the additional funds necessary to pursue the project, as it has negative NPV. D) Investors are unsure of the value for ABC Co. ABC Co. decides to issue equity to pay down debt. The market assumes that ABC Co.'s managers are issuing equity because they think that the company's stock is overvalued. As a result, the company's stock price falls when the equity issue is announced. Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

66. The claim lenders' hold on cash flows in a company with outstanding risky debt is often thought of as: A) holding a call option on the firm's assets. B) holding a put option on the firm's assets. C) selling a put option on the firm's assets and holding a risk-free bond. D) selling a call option on the firm's asset and holding a risk-free bond. Ans: C

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Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium 67. Adding stock options and bonuses for performance to the compensation of a manager is intended to closer align the interest of the manager with: A) stockholders. B) lenders. C) employees. D) public. Ans: A

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

68. What is the payoff for a call option with a strike price of $50 if the underlying stock price at expiration is $85? A) $35 B) $50 C) $45 D) $140 Ans: A Feedback: (Call) Payoff = Stock price – Strike price = $85 – $50 = $35

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

69. What is the payoff for the owner of a call option with a strike price of $35 if the underlying stock price at expiration is $30? A) $10 B) $20 C) $5 D) $0 Ans: D Feedback: The payoff for the owner of a call option is zero as the value of the underlying asset, .

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Fundamentals of Corporate Finance 3e

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$30 is below the exercise price of $35.

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

70. What is the payoff for the owner of a put option with a strike price of $63 if the underlying stock price at expiration is $43? A) $126 B) $43 C) $20 D) $63 Ans: C Feedback: Payoff for the owner of a put option = Strike price – Stock price = $63 – $43 = $20

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

71. You own a put option on Phosfranc Inc. stock with a strike price of $50. The current stock price is $50. In which of the following cases your benefit will increase? A) If the stock price goes up B) If the stock price goes down C) If the stock price stays the same D) Benefit is indifferent to the changes in the stock price. Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

72. You have sold a call option on Ausia Co. stock with a strike price of $50. You do not intend to make any other transactions before the options expiration date. The current stock price is $30. Which of the following statements best describes your hopes for the stock? A) You want the stock price to fall below $30. B) You want the stock price to rise above $50. C) You are indifferent, as long as the stock price stays under $50. D) It doesn't matter; you are indifferent to changes in the stock price. Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

73. What is the payoff for a put option with a strike price of $22 if the price of the underlying stock at expiration is $19? A) $1 B) $3 C) $20 D) $22 Ans: B Feedback: Payoff for the owner of a put option = Strike price – Stock price = $22 – $19 = $3

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

74. Consider a call option with a strike price of $20, which expires in one year. The riskfree rate of interest is 5 percent. The underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? (Round intermediate computations to two decimal places.) A) $0 B) $8 C) $15 D) $1 Ans: C Feedback: Without arbitrage, the value of the option must fall between $10.95 and $30. Out of the given choices, only $15 is a possible price for the option.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

75. Consider a call option with a strike price of $10, which expires in one year. The riskfree rate of interest is 10 percent. The current underlying stock price is $30. Without arbitrage, which of the following is a possible price for the call option? (Round intermediate computations to two decimal places.) A) $0 B) $19.50 C) $21.00 D) $19.00 Ans: C Feedback: Without arbitrage, the value of the option must fall between $20.91 and $30. Out of the given choices, only $21 is a possible price for the option.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

76. Consider a put option with a strike price of $40, which expires in one year. The riskfree rate of interest is 8 percent. The current underlying stock price is $20. Without arbitrage, which of the following is a possible price for the put option? (Round intermediate computations to two decimal places.) A) $0.50 B) $16.20 C) $25.00 D) $10.20 Ans: C Feedback: Without arbitrage, the value of the put option must fall between $17.04 and $19.04. 37.04 Out of the given choices, only $25 is a possible price for the option.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

77. Pitchgent, Inc., stock is currently trading at $22 per share. There are two types of options available on the stock. Call options with a strike price of $16, which expire next month, are currently trading at $7.00. Put options with a strike price of $16 which expire next month are currently trading at $1.10. Larry invests $132 in common stock. Keaty invests $132 in the call options. Marek invests $132 in the put options. At the end of one month, the price of Pitchgent, Inc., is $25. Who made the most money off of their investment? A) Larry B) Keaty C) Marek D) Larry and Keaty tied Ans: B Feedback: Larry holds ($132) / ($22) per share = 6 shares of stock. His gain is (6 shares) × ($25 per share) – $132 = $18 Keaty holds ($132) / ($7 per call option) = 18.857 call options. The final price of the stock is above the $16 strike price, so her options are in the money. Her gain is ($25 – $16) × (18.857 call options) – $132 = $37.714 Marek holds ($132) / ($1.1 per put option) = 120 put options. The final price of the stock is above the $16 strike price, so his options are out of the money. He received no payoff. His loss is –$132. Keaty made the most money.

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

78. Tunerecord Unit Co. stock is currently trading at $24. There are two types of options available on the stock. Call options with a strike price of $24, which expire next year, are currently trading at $9.6. Put options with a strike price of $24, which expire next year, are currently trading for $2.4. Berniss invests $144 in common stock. Jewel invests $144 in the call options. Reynardo invests $144 in the put options. At the end of one year the price of Tunerecord Unit stock is $21.6. Who made the least losses off of their investment? A) Berniss B) Jewel C) Reynardo D) Berniss and Jewel tied Ans: C Feedback: Berniss holds ($144) / ($24) per share = 6 shares of stock. The stock went down, so Berniss lost money. His loss is (6 shares) × ($21.6 per share) – $144 = –$14.4. Jewel holds ($144) / ($9.6 per call option) = 15 call options. The final price of the stock is below the $21.6 strike price, so her options are out of the money. There is no payoff from her call options. Her loss is –$144. Reynardo holds ($144) / ($2.4 per put option) = 60 put options. The final price of the stock is below the $24 strike price, so his options are in the money. His gain is ($24 – $21.6) × (60) – $144 = 0. Reynardo broke even, the others lost money.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

79. Assume that the stock of Alitor Craft, Inc,. is currently trading for $19 and will either rise to $21 or fall to $15 in one year. The risk-free rate for one year is 12 percent. What is the value of a call option with a strike price of $16? (Do not round intermediate computations. Round final answer to two decimal places.) A) $4.67 B) $2.33 C) $1.04 D) $6.83 Ans: A Feedback: The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $5 = ($21 × x) + (1.12 × y) $0 = ($15 × x) + (1.12 × y) The first equation can be written in terms of x as follows: $5 – (1.12 y) x = $21 Now, substituting into the second equation gives us: $0 = $15 ×

$5 – (1.12 y) $21

+ 1.12 y

1.12y = –$12.5 y = –$11.16 Finally, substituting this value back into the first equation gives us the value of x: $5 = ($21× x) + (1.12 × –$11.16) x = 0.833 The value of the option is the value of the replicating portfolio: (0.833 × $19) + (1 × (–$11.16)) = $4.67

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

80. Assume that the stock of Tencheck, Inc., is currently trading for $45 and will either rise to $57 or fall to $19 in one year. The risk-free rate for one year is 9 percent. What is the value of a call option with a strike price of $47? (Do not round intermediate computations. Round final answer to two decimal places.) A) $3.40 B) $6.84 C) $8.84 D) $7.25 Ans: D Feedback: The payoff from the call option is $10 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $10 = ($57 × x) + (1.09 × y) $0 = ($19 × x) + (1.09 × y) the first equation can be written in terms of x as follows: $10 - (1.09 y) x = $57 Now, substituting into the second equation gives us:

$0 = $19 ×

$10 - (1.09 y) $57

+ 1.09 y

1.09 y = – $5 y = –$4.59 Finally, substituting this value back into the first equation gives us the value of x: $10 = ($57 × x) + (1.09 × –$4.59) x = 0.263 The value of the option is the value of the replicating portfolio: (0.263 × $45) + (1 × (–$4.59)) = $7.25

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

81. XYZ, Inc., stock is currently trading for $47 and will either rise to $49 or fall to $44 in one year. The risk-free rate for one year is 6 percent. You own a call option with a strike price of $32, which expires in one year. What is the value of your call option? (Do not round intermediate computations. Round final answer to two decimal places.) A) $0 B) $5.27 C) $10.05 D) $16.81 Ans: D Feedback: The payoff from the call option is $17 if the stock price rises and $12 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $17 = $49 x + 1.06 y $12 = $44 x + 1.06 y $17 - (1.06 y) x = $49 Now, substituting into the second equation gives us:

$12 = $44 ×

$17 - (1.06 y) $49

+ 1.06 y

1.06 y = –$32.00 y = –30.19 Finally, substituting this value back into the first equation gives us the value of x: $17 = $49 x + 1.06 × (–$30.19) x=1 The value of the option is the value of the replicating portfolio: (1 × $47) + (1 × (–$30.19)) = $16.81

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

82. Assume that the stock of XYZ, Inc., is currently trading for $18 and will either rise to $24 or fall to $13 in one year. The risk-free rate for one year is 11 percent. What is the value of a call option with a strike price of $26? A) $0 B) $5.23 C) $7.72 D) $2.00 Ans: A Feedback: The payoff from the call option is $0 if the stock price rises and $0 if the stock price falls. This option will never payoff, so it has a value of $0. Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Quantitative Methods AICPA: Industry/Sector Perspective

83. The standard deviation of the return on a stock is 25% per year. Compute the standard deviation over two years. (Round your intermediate answer to 3 decimal places.) A) 30.35% B) 35.35% C) 12.25% D) 25.00% Ans: B Feedback: σ2 years = σ × (n)1/2 = 25 × (2 years) 1/2 = 25 × 1.414 = 35.35%

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

84. Phocuscorp’s stock is currently worth $60. The replicating portfolio consists of one-half share and $24.50 risk-free loan. Compute the value of call option. A) $5.5 B) $4.5 C) $5.0 D) $6.0 Ans: A Feedback: Value of the call option today = C = ($60 × x) + (1 × y) = ($60 × 0.5) + (1 × – $24.5) = $5.5

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

85. Assume that the stock of Unmix, Inc., is currently trading for $22 and will either rise to $31 or fall to $18 in one year. Assume the risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $25? (Round the final answer to two decimal places.) A) $0 B) $1.85 C) $3.00 D) $4.85 Ans: D Feedback: The payoff from the put option is $0 if the stock price rises and $7 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($31 × x) + (1.00 × y) $7 = ($18 × x) + (1.00 × y) x = –0.538 shares of stock y = $16.69 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.538 × $22) + ($16.69) = $4.85 .

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

86. Assume that the stock of AllSiete, Inc., is currently trading for $44 and will either rise to $50 or fall to $29 in one year. The risk-free rate for one year is 4 percent. What is the value of a put option with a strike price of $40? (Round the final answer to two decimal places.) A) $0 B) $2.20 C) $3.14 D) $5.54 Ans: B Feedback: The payoff from the put option is $0 if the stock price rises and $11 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($50 × x) + (1.04 × y) $11 = ($29 × x) + (1.04 × y) x = –0.52 shares of stock y = $25.08 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.52 × $44) + ($25.08) = $2.20

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

87. Assume that the stock of Phoneeffect, Inc., is currently trading for $16 and will either rise to $23.50 or fall to $9 in one year. The risk-free rate for one year is 3 percent. What is the value of a put option with a strike price of $18 that expires in three months? (Do not round intermediate computations. Round final answer to two decimal places.) A) $0 B) $2.75 C) $4.23 D) $5.73 Ans: C Feedback: The payoff from the put option is $0 if the stock price rises and $9 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($23.50 × x) + (1.03 × y) $9 = ($9 × x) + (1.03 × y) x = –0.621 shares of stock y = $14.16 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.621 × $16) + ($14.16) = $4.23

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

88. Assume that the stock of TuneSeis, Inc., is currently trading for $29 and will either rise to $32 or fall to $5 in one year. The risk-free rate for one year is 2 percent. What is the value of a put option with a strike price of $30? (Do not round intermediate computations. Round final answer to two decimal places.) A) $0 B) $0.41 C) $1.78 D) $2.20 Ans: D Feedback: The payoff from the put option is $0 if the stock price rises and $25 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($32 × x) + (1.02 × y) $25 = ($5 × x) + (1.02 × y) x = –0.926 shares of stock y = $29.05 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.926 × $29) + ($29.05) = $2.20

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

89. Assume that the stock of Mixtoss, Inc., is currently trading for $18 and will either rise to $30 or fall to $12 in one year. Assume the risk-free rate for one year is 0 percent. What is the value of a put option with a strike price of $15? (Do not round intermediate computations.) A) $0 B) $2 C) $5 D) $6 Ans: B Feedback: The payoff from the put option is $0 if the stock price rises and $3 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $3 = ($12 × x) + (1.00 × y) x = –0.167 shares of stock y = $5 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.167 × $18) + ($5) = $2 Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

90. If the value of the underlying asset is well above the exercise price of put option then: A) it is likely that the option will be exercised by the buyer. B) the exercise price remains constant irrespective of the change in the value of the underlying asset. C) the value of the option is directly proportional to the value of the underlying asset. D) the seller of the option will most likely make a profit. Ans: D

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

91. Assume that the stock of Statrec, Inc., is currently trading for $2.60 and will either rise to $10 or fall to $0 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $5? (Do not round intermediate computations. Round final answer to two decimal places.) A) $0 B) $2.35 C) $3.65 D) $3.80 Ans: C Feedback: The payoff from the put option is $0 if the stock price rises and $5 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($10 × x) + (1.01 × y) $5 = ($0 × x) + (1.01 × y) x = –0.5 shares of stock y = $4.95 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.5 × $2.6) + ($4.95) = $3.65

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

92. You own a share of common stock in Vibrapower, Inc., which is currently trading for $18 and will either rise to $30 or fall to $12 in one year. Assume the risk-free rate for one year is 0 percent. You also own an American put option on the stock with a strike price of $20, which expires in one year. What is the value of the put option, and what would be the net payoff from exercising the option now? (Do not round intermediate computations. Round final answer to two decimal places.) A) Option value: $3.33, Net payoff $2 B) Option value: $3.33, Net payoff $6 C) Option value: $5.33, Net payoff $2 D) Option value: $5.33, Net payoff $6 Ans: C Feedback: First, we can calculate the value of the put option with the binomial model. The payoff from the put option is $0 if the stock price rises and $8 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $8 = ($12 × x) + (1.00 × y) x = –0.444 shares of stock y = $13.33 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.444 × $18) + ($13.33) = $5.33 The payoff from exercising the put option now is the option strike price minus the current stock price: $20 – $18 = $2

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

93. You are fortunate enough to own a put option with a strike price of $40 on the stock of Osmerc, Inc. The current stock price is $3. When the option expires, you expect the stock price to be either $2 or $5. Assume the risk-free rate of interest is zero. What is the value of your option? A) $0 B) $35 C) $37 D) $46 Ans: C Feedback: The payoff from the put option is $35 if the stock price rises and $38 if the stock price falls. When the put option pays off in either state, the value of the option is strike price minus the current stock price. $40 – $3 = $37

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

94. Assume that the stock of EffeUn, Inc., is currently trading for $16 and will either rise to $18 or fall to $12 in one year. The risk-free rate for one year is 1 percent. What is the value of a put option with a strike price of $10? A) $0 B) $2.00 C) $2.33 D) $5.00 Ans: A Feedback: The payoff from the put option is $0 if the stock price rises and $0 if the stock price falls. Either way the put option has no payoff. The value of this put option is $0.

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

95. Assume that the stock of ABC, Inc., is currently trading for $21 and will either rise to $30 or fall to $18 in one year. Assume the risk-free rate for one year is 0 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $25, and both expire in one year. What is the value of your portfolio? (Do not round intermediate computations. Round final answer to one decimal place.) A) $4.5 B) $25.0 C) $6.0 D) $6.5 Ans: D Feedback: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then we can add the values together. The payoff from the call option is $5 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $5 = ($30 × x) + (1.00 × y) $0 = ($18 × x) + (1.00 × y) x = 0.417 shares of stock y = –$7.5 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.417 × $21) + (–7.5) = $1.25 The payoff from the put option is $0 if the stock price rises and $7 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($30 × x) + (1.00 × y) $7 = ($18 × x) + (1.00 × y) x = –0.583 shares of stock y = $17.5 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.583 × $21) + ($17.5) = $5.25 The total value of the portfolio is $1.25 + $5.25 = $6.5

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

96. Assume that the stock of DiezEight, Inc., is currently trading for $16 and will either rise to $50 or fall to $2 in one year. The risk-free rate for one year is 8 percent. You own a portfolio that consists of one call option and one put option. Both options have a strike price of $15, and both expire in one year. What is the value of your portfolio? (Do not round intermediate computations. Round final answer to two decimal places.) A) $0 B) $15.64 C) $21.40 D) $18.52 Ans: D Feedback: To calculate the value of this portfolio, we can use the binomial pricing model to calculate that value of the call and the put. Then we can add the values together. The payoff from the call option is $35 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $35 = ($50 × x) + (1.08 × y) $0 = ($2 × x) + (1.08 × y) x = 0.729 shares of stock y = –$1.35 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.729 × $16) + (–1.35) = $10.31 The payoff from the put option is $0 if the stock price rises and $13 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($50 × x) + (1.08 × y) $13 = ($2 × x) + (1.08 × y) x = –0.271 shares of stock y = $12.54 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.271 × $16) + ($12.54) = $8.21 The total value of the portfolio is $10.31 + $8.21 = $18.52

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

97. Consider two call options written on different stocks. Both call options have a strike price of $15 and expire one year from today. The first option is written on HearFour, Inc., whose current stock price is $16. One year from now, shares of HearFour will either rise to $18 or fall to $14. The second option is written on EsoOne, Inc., whose current stock price is also $16. One year from now shares of EsoOne Inc. will either rise to $22, or fall to $0. The risk-free interest rate is 0 percent. Which call option is worth more? A) The call option on HearFour, is worth more. B) The call option on EsoOne is worth more. C) They are both worth the same amount. D) There is not enough information to make a comparison. Ans: B Feedback: First we can price the HearFour call option. The payoff from the HearFour call option is $3 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $3 = ($18 × x) + (1.00 × y) $0 = ($14 × x) + (1.00 × y) x = 0.75 shares of stock y = –$10.50 of risk free bonds The value of the option is the value of the replicating portfolio: (0.75 × $16) + (–10.50) = $1.50 Next we can price the EsoOne call option. The payoff from the EsoOne call option is $7 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $7 = ($22 × x) + (1.00 × y) $0 = ($0 × x) + (1.00 × y) x = 0.32 shares of stock y = $0 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.32 × $16) + ($0) = $5.09 The EsoOne call option is worth more.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

98. Consider a call option and a put option both written on Neunlay, Inc. stock. Both options have a strike price of $20 and expire in one year. The stock of Neunlay, Inc., is currently selling for $20. In one month the stock will be at either $24 or $18. Assume the risk-free rate is 0 percent. Which is worth more, the put option or the call option? A) The put option is worth more. B) The call option is worth more. C) They are worth the same. D) There is not enough information. Ans: C Feedback: The payoff from the call option is $4 if the stock price rises and $0 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $4 = ($24 × x) + (1.00 × y) $0 = ($18 × x) + (1.00 × y) x = 0.67 shares of stock y = –$12 of risk-free bonds The value of the option is the value of the replicating portfolio: (0.67 × $20) + (–12) = $1.33 The payoff from the put option is $0 if the stock price rises and $2 if the stock price falls. From the binomial pricing model we can create a replicating portfolio with the following two equations: $0 = ($24 × x) + (1.00 × y) $2 = ($18 × x) + (1.00 × y) x = –0.333 shares of stock y = $8 of risk-free bonds The value of the option is the value of the replicating portfolio: (–0.333 × $20) + ($8) = $1.33 The call and the put options are worth the same. Note that this is a special case where interest rates are zero. With a positive interest rate, the call will be worth more than the put.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

99. The value of call option can never be less than _____ A) $0 B) $1 C) strike price D) value of under lying asset Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

100. When we consider the value of a call option at some time prior to expiration, we must: A) compare the current value of the underlying asset with the present value of the cash flow by underlying asset, discounted at the risk-free rate. B) compare the current value of the underlying asset with the present value of the exercise price, discounted at the risk-free rate. C) compare the current value of the underlying asset with the present value of the cash flow by underlying asset, discounted at the nominal rate. D) compare the current value of the underlying asset with the present value of the exercise price, compounded at the nominal rate. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard 101. Which of the following is true of a call option? A) The value of a call option must be less than or equal to $0. B) The value of a call option cannot be lower than the value of the underlying asset. C) The value of a call option prior to expiration will never be less than the value of the option if it were exercised immediately. D) A call option protects the seller from price volatility. Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

102. Calculate the value of put option with the given information. Value of the call option is $6.2, Exercise price is $58, risk-free rate of interest is 5.5%, time before the option expires is one year and the current value of underlying assets is $52. Consider the value for ‘e’ as 2.71828. A) $9.10 B) $12.20 C) $6.20 D) $8.92 Ans: A Feedback: The value of put option can be computed using the equation of put-call parity. P = C + Xe–rt – V P = $6.2 + $58 × (2.71828)–(0.055)(1) – $52 P = $9.10

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

103. Trerec Co. is a privately owned oil drilling and refinery company with a significant amount of debt. Most of the company's cash flows come from the financially stable refinery unit of the business. With only the assets in place, the company is very likely to avoid financial distress for the foreseeable future. Avoiding financial distress is very important to the owners, who founded the company. The company is considering a new oil drilling project, determined to have a positive NPV. Because of the nature of oil prices, the project is very risky. At any oil price above $115, the project would add value to the company. However, if oil prices were to fall below $95 the losses could push the entire business into financial distress. Assume the risk-free interest rate is 0 percent. Which of the following strategies would allow the firm to pursue the positive NPV project while hedging the oil price risk? A) The firm purchases call options with a strike price of $130 for each barrel of oil it expects to produce. Each option costs $6. B) The firm sells call options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6. C) The firm purchases put options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6. D) The firm sells put options with a strike price of $130 on each barrel of oil it expects to produce. Each option costs $6. Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

104. Consider a corn farmer who expects to produce 55,000 bushels of corn at the end of this season. To hedge the risk associated with corn prices, the farmer purchases put options to cover his entire crop. The put options have a strike price of $8.50 per bushel and a premium of $0.40 per bushel. He also sells an equal amount of call options with a strike price of $8.50 per bushel and a premium of $0.53 a bushel. Which of the following statements is correct? A) From this transaction the farmer can pocket $7,500 immediately. B) If corn prices go up substantially, the farmer will earn more money. C) The put options guarantee that the farmer will receive at least $7.63 per bushel at the end of the season. D) The farmer has guaranteed that he will sell his corn for $8.50 a bushel. Ans: D

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

105. Consider a lease agreement recently offered by a car dealership. The agreement gives the customer the right to use a new SUV for 4 years in exchange for payments of $650 per month. At the end of the lease, the customer can choose to purchase the SUV for $18,000. What sort of option does this resemble? A) A put option on the SUV with a strike price of $18,000 B) A call option on the SUV with a strike price of $18,000 C) A put option on the SUV with a strike price of $17,800 D) A call option on the SUV with a strike price of $17,800 Ans: B

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

106. Neunlay Inc., is a manufacturer of residential air conditioning equipment. Air conditioning equipment requires a lot of copper. In six months the company will purchase its copper supply for the next two years. Management is very concerned about the volatility of copper prices. Assume the risk-free rate of interest is 0 percent. Which of the following transactions will ensure the company does not have to pay more than $6,100 per ton of copper six months from now? A) The company purchases a put option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now. B) The company purchases a call option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now. C) The company sells a put option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton and an expiration date six months from now. D) The company sells a call option for the necessary amount of copper with a strike price of $6,000 per ton, a premium of $100 per ton, and an expiration date six months from now. Ans: B

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Hard Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

107. Describe the difference between American call options and American put options. Include in your answer a description of the option premium, the option strike price, the expiration date, and the payoff function. Ans: The buyer of an American call option pays the seller a premium for the right to purchase the underlying asset at the strike price, before or on the expiration date. Because the buyer of the option has the right, but not the obligation, to purchase the asset, he will only exercise the option if the asset is worth more than the strike price. The payoff function for a call option is zero until the value of the underlying asset reaches the strike price. If the price of the underlying asset is above the strike price, the payoff function is equal to the difference between the asset price and the strike price. The buyer of an American put option pays the seller a premium for the right to sell the underlying asset at the strike price, before or on the expiration date. Because the buyer of the option has the right, but not the obligation, to sell the asset, he will only exercise the option if the asset is worth less than the strike price. The payoff function for a put option is zero if the value of the underlying asset is higher than the option's strike price. If the value of the underlying asset is lower than the strike price, the payoff of the put option is equal to the difference between the strike price and the underlying asset price.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Knowledge AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

108. Name the factors that affect the value of a call option and explain the direction of the effects. Ans: Five factors affect the value of a call option. The Strike Price of the Option—All else equal, the lower the strike price of the call option, the more valuable the option is. This is true because with a low strike price, the underlying asset price will not have to be as high for the option to be “in the money.” The Price of the Underlying Asset—All else equal, the higher the price of the underlying asset, the more valuable a call option on the asset is. If the price of the underlying asset is higher, it is more likely to be above the strike price at the expiration date. The Volatility of the Underlying Asset—All else equal, the higher the volatility of the price of an asset, the more a call option is worth. With higher volatility, the price of the underlying asset has a higher chance of going significantly down or up before the expiration date. Because the call option will only be exercised if the underlying asset price is above the strike price, the benefits from the upside of volatility outweigh the negatives from the downside of volatility. Time until Expiration of the Option—All else equal, the longer until an option expires, the more it is worth. The effect of the time until expiration is similar to the effect of volatility. With more time until maturity, the price of the underlying asset is more likely to significantly increase or decrease. The Risk-Free Interest Rate—The value of a call option increases with the riskfree interest rate. The present value of the strike price decreases with the risk-free rate. Since a call option involves paying the strike price in the future, a higher risk-free rate increases the value of the option.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Analysis AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

109. You're brought in to consult on a project for Sanpharm Corp., which is considering whether or not to build a new high-tech manufacturing facility. Give four examples of real options that you would consider when evaluating the project. Ans: Real options fall into four categories: options to defer investment, options to change operations, options to abandon projects, and to make follow-on investments. Many examples of real options might be included in this steel project. The following list gives one example from each category of real option. The option to defer investment. The firm may consider postponing the project until it has more information about the costs and benefits of the project. For example, the company may learn that the plant will be less profitable than expected. Suppose that during the next year costly environmental regulations are enacted, or the price of steel goes down. The company should take these considerations into account when deciding if now is the best time to build the plant. The option to change operations. The company must consider whether it will have the flexibility to change the way the plant is operated. For example, if the demand for steel falls, it might be able shut down the plant temporarily and reduce costs. Alternatively, it might be able to produce other metals, such as bronze or brass, if it becomes more profitable to do so. The option to abandon the project. The company should consider what it might be able to do with the project if it fails or it becomes unprofitable to continue. It might decide to construct the facility in such a way that it can accommodate other manufactures in the event it has to liquidate the plant. The option to make follow-on investments. The firm should consider whether any follow-on investments may spring from this project. For example, it might consider whether it can expand the plant to increase production if demand for steel is high. It might also consider whether the new production process might be retrofitted to its existing plants, if the project is successful.

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Fundamentals of Corporate Finance 3e

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Format: Essay Learning Objective: LO 4 Level of Difficulty: Hard Bloomcode: Comprehension AASCP: Analytic IMA: Corporate Finance AICPA: Industry/Sector Perspective

110. What are agency costs in corporate finance, and how do they relate to options? Ans: Agency costs arise when the interests of stockholders, lenders, and managers are not perfectly aligned. These costs often arise because the payoff functions for these different claimholders look like different types of options. One broad category is the agency costs of debt. When the firm has debt, the payoff function of stockholders looks similar to a call option on the firm's assets. The face value of debt is similar to the strike price on a call option. Because of this option-like payoff function, the stockholders have an incentive to take actions that increase the value of the stockholder's claim, but may reduce the total value of the firm. Examples of agency problems from debt include the dividend payout problem, the asset substitution problem, and the underinvestment problem. Another broad category of agency costs is the agency costs of equity. This describes the difference between the interests of stockholders and managers. The payoff function for a salary-only manager is similar to a portfolio consisting of a risk-free bond and a put option. If the company performs well, the manager is not likely to see much additional benefit. However, if the company enters financial distress, the manager is likely to be fired and lose much of his or her future wealth. This option-like payoff gives the managers an incentive to avoid risky projects that might increase the probability of financial distress, even if the project has a positive NPV. Turning down positive-NPV projects reduces the total value of the firm. Often the compensation for senior managers contains additional payoffs for good performance to more closely align their incentives with those of shareholders.

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Chapter 21: International Financial Management Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 1. Globalization refers to the removal of barriers to free trade and the closer integration of national economies. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 2. While the production of goods and services has become globalized, American consumers only purchase domestic goods. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 3. The production of goods and services has become highly globalized due to emergence of large multinational companies. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 4. Integration of the financial system globally is a result of deregulation of foreign exchange markets, money and capital markets, and banking systems. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 5. A transnational corporation is a business firm that operates in more than one country but is headquartered or based in its home country. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 6. Royal Dutch Shell is a transnational corporation. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 7. Differences in legal systems and tax codes have no impact on the way firms operate in foreign countries. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 8. Legal systems can vary on simple matters, such as opening a business, selecting a site location, and hiring employees. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 9. English is the world's social language. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 10. English is the language for international business, but not the world's social language. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 11. Cultural views shape business practices and people's attitudes toward business. A) True B) False Ans: A

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 12. Both China and the nations that formerly made up the Soviet Union are currently moving toward centrally planned economies. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 13. Country risk has no effect on a firm's cash flows. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 14. Stockholder wealth maximization is the accepted goal for firms in all countries around the world. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 15. The European manager's goal is to earn as much wealth as possible for a firm while considering the overall welfare of both the stockholders and stakeholders. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 16. European firms focus on maximizing market share rather than stockholder wealth. A) True B) False Ans: B

Format: True/False Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 17. Japanese managers focus on maximizing market share rather than stockholder wealth. A) True B) False Ans: A

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 18. The foreign exchange market is a group of international markets connected electronically where currencies are bought and sold in wholesale amounts. A) True B) False Ans: A

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 19. Tokyo is the largest foreign exchange trading center. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 20. When a U.S. bank in Chicago gives a quote of £0.5089/$, it is a direct quote. A) True B) False Ans: B

Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 21. If the exchange rate is the price in foreign currency for a dollar, the quote is called direct quote. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 22. The bid quote is the rate at which the dealer will sell foreign currency. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 23. The decision to accept international projects with a positive NPV increases the value of a firm, and it should be consistent with maximizing stockholder wealth. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 24. Most companies find it easier to estimate the incremental cash flows for foreign projects than for domestic projects. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 25. To convert a project's future cash flows into another currency, we need to come up with projected or forecast exchange rates. A) True B) False Ans: A

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 26. To convert a project's future cash flows into another currency, we need to use today's spot exchange rates. A) True B) False Ans: B

Format: True/False Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 27. If a firm is located in a country with a relatively unstable political environment, management will require a lower rate of return on capital projects. A) True B) False Ans: B

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Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 28. A Eurodollar is defined as a U.S. dollar deposited in a bank outside the United States. A) True B) False Ans: A

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 29. Long-term loans of a Eurocurrency made to multinational corporations and governments of poor credit quality are called Eurocredits. A) True B) False Ans: B

Format: True/False Learning Objective: LO 4 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 30. Eurodollar and other Eurocurrency bonds have all characteristics identical to similar U.S corporate bonds. A) True B) False Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 31. Evidence of globalization include A) consumers in many countries buy goods that are purchased from a number of countries, other than just their own. B) goods and services are produced around the world. C) the financial system has also become highly integrated. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 32. Which of the following statements about multinational firms is NOT true? A) A multinational corporation is a business firm that operates in more than one country but is headquartered or based in its home country. B) Multinational corporations are owned by domestic stockholders only. C) Multinational corporations may purchase raw materials from one country, obtain financing from a capital market in another country, and produce finished goods with labor and capital equipment from a third country. D) All of these Ans: B

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Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 33. Factors that can cause international business transactions to differ from domestic deals include all EXCEPT A) exchange rate risk, legal systems, and country risk. B) legal systems, cultural factors, and economic systems. C) Time value of money,expected returns procedures, and size of market. D) economic systems, cultural factors, and country risk Ans: C

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 34. Which of the following statements about the goal of a firm is true? A) Stockholder value maximization is the accepted goal for firms in India. B) Firms in Germany focus on maximizing corporate wealth. C) The goal of a Japanese business manager is to increase the wealth and growth of the keiretsu. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 1 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 35. Which of the following statements about the goal of a firm is true? A) Corporate wealth maximization is the accepted goal for firms in India. B) Firms in Australia focus on maximizing corporate wealth. C) The goal of a Japanese business manager is to increase the wealth and growth of the keiretsu. D) Private-sector firms in China focus on providing full employment in the economy. Ans: C

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic4 IMA: Global Business AICPA: Industry/Global Perspective 36. Economic benefits provided by the foreign exchange markets include A) a mechanism to transfer purchasing power from individuals who deal in one currency to people who deal in a different currency. B) a way for corporations to pass the risk associated with foreign exchange price fluctuations to professional risk-takers. C) a channel for importers and exporters to acquire credit for international business transactions. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 37. In 2010, the three largest foreign exchange markets based on daily volume are A) London, New York, and Tokyo. B) New York, Tokyo, and Zurich. C) London, Tokyo, and Zurich. D) London, New York, and Singapore. Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 38. The major participants in the foreign exchange markets are A) multinational commercial banks, large investment banking firms, and domestic firms. B) multinational commercial banks, local banks and domestic firms. C) multinational commercial banks, large investment banking firms, and small currency boutiques. D) None of these Ans: C

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 39. Which of the following statements is true? A) Equilibrium occurs at the price at which the quantity of the currency demanded exactly equals the quantity supplied. B) When pounds become less expensive in relation to dollars, British products become less expensive for Americans to buy. C) According to a British buyer, the lower the dollar price of pounds, the greater the number of pounds that must be given up to obtain dollars to buy foreign goods. D) All of these Ans: D

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 40. If the foreign exchange rate is the price in foreign currency for a dollar, then the exchange rate quote is called A) an American quote. B) an indirect quote. C) a direct quote. D) a cross quote. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 41. A European quote is the same as A) an American quote. B) an indirect quote. C) a bidding quote. D) a cross quote. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 42. Which of the following is an indirect quote from an American perspective? A) £0.5125/$ B) $0.006900/¥ C) $1.5637/€ D) ¥115.23/€ Ans: A

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 43. The bid quote represents the rate at which A) the dealer will buy foreign currency from you. B) the dealer will sell foreign currency to you. C) the dealer will buy domestic currency from you. D) the dealer will sell domestic currency to the exchange. Ans: A

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 44. The ask quote represents the rate at which A) the dealer will buy foreign currency from you. B) the dealer will sell foreign currency to you. C) the dealer will buy domestic currency from the exchange. D) the dealer will sell domestic currency to you. Ans: B

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Easy Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 45. The difference between the forward rate and the spot rate is called the A) cross exchange rate. B) forward premium or forward discount. C) indirect quote. D) direct quote. Ans: B

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 46. Venkat Ram purchased a pair of dress shoes in Italy for €131.25. If the spot exchange rate is $1.5621/€, what is the dollar cost of the shoes? (Round your final answer to two decimal places.) A) $205.03 B) $84.02 C) €131.25 D) €84.02 Ans: A Feedback: Cost of shoes in Italy = €131.25 Spot rate = $1.5621/€ Dollar cost of shoes = €131.25 × $1.5621/€ = $205.03

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 47. Starling, Corp. purchased some components from a Mexican manufacturer. They have to pay 110 million Mexican Pesos for the goods today. The spot rate today is MP10.3540/$. What is the dollar cost of this payable? (Round your final answer to the nearest dollar.) A) $110,000,000 B) $10,623,913 C) $11,110,235 D) $1,138,940,000 Ans: B Feedback: Cost of payables = MP 110,000,000 Spot rate = MP 10.3540/$ Dollar cost of payables = MP 110,000,000 / MP 10.3540/$ = $10,623,913.46 or $10,623,913

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 48. Tantrix, Inc. purchased its inventory from an Indian manufacturer at a cost of Rs.5,325,000. The dollar cost of this payable is $125,634.07 at today's spot rate. What is the spot rate today? A) $4.2385/Rs. B) $42.3850/Rs. C) Rs.42.3850/$ D) Rs.4.2385/$ Ans: C Feedback: Inventory cost to firm = Rs.5,325,000 Dollar cost of purchase = $125,634.07 Spot rate at which the foreign currency revenue was converted: Rs. 5,325,000 = Rs. 42.3850 $125,634.07 This is the same as $0.0236/Rs.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Analysis AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 49. Suppose a Tata Nano car is priced at Rs.100,000 in New Delhi and $3,129 in New York. In which place is the car more expensive if the spot rate is $0.0242/Rs.? A) In New Delhi B) In New York C) It is same in both places. D) It cannot be determined. Ans: B Feedback: Cost of car in New York = $3,129 Cost of car in New Delhi = Rs.100,000 Spot rate = $0.0242/Rs. Dollar cost in New Delhi = Rs.100,000 × $0.0242/Rs. = $2,420 The cost of the car is the higher in New York based on the spot rate.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 50. If the spot rate is quoted as $0.009369/¥, what is the exchange rate in terms of yen per dollar? (Round your final answer to the four decimal places.) A) ¥0.009369/$ B) ¥0.936900/$ C) ¥106.7350/$ D) ¥16.7350/$ Ans: C Feedback: Spot rate = ¥0.009369/$ Direct quote = 1/ $0.009369/¥ = ¥106.7350/$

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 51. Given that the spot rate is $1.5136/€ and the 90-day forward quote is $1.4974/€, we can say that A) the U.S. dollar is at a forward premium against the Euro. B) the U.S. dollar is at a forward discount against the Euro. C) the Euro is at a forward premium against the U.S. dollar. D) the dollar is at neither a premium nor a discount against the Euro. Ans: A Feedback: Since the forward quote of $1.4974/€ implies that fewer dollars will be needed to purchase the Euro compared to the spot rate of $1.5136/€, we can say that the U.S. dollar is at a forward premium against the Euro.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 52. Given that the spot rate is ¥106.74/$ and the 180-day forward quote is ¥100.37/$, we can say that A) the U.S. dollar is at a forward premium against the Yen. B) the Yen is at a forward premium against the U.S. dollar. C) the Yen is at a forward discount against the U.S. dollar. D) the U.S. dollar is at neither a premium nor a discount against the Yen. Ans: B Feedback: Since the forward quote of ¥100.37/$ implies that fewer yen will be needed to purchase a dollar compared to the spot rate of ¥106.74/$, we can say that the U.S. Dollar is at a forward discount against the Yen, or that the yen is at a forward premium against the U.S. dollar.

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 53. Celio, Inc. sold equipment to a French firm and will receive €1,249,425 in 30 days. If the company entered a forward contract to sell the euros at the 30-day forward rate of $1.5512/€, what is the dollar revenue received? (Round your final answer to the nearest dollar.) A) $1,249,425 B) $805,457 C) $1,938,108 D) $1,312,224 Ans: C Feedback: Expected euro revenue = €1,249,425 30-day forward rate = $1.5512/€ Dollar revenue received = €1,249,425 × $1.5512/€= $1,938,108

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 54. Baljit, Inc. purchased machinery from a Japanese firm and will have to pay ¥278.45 million in 90 days. The bank quotes a forward rate of ¥105.46/$ to buy the required yen. What is the cost to Baljit in U.S. dollars? (Round your final answer to the nearest dollar.) A) $2,640,338 B) $2,784,500 C) $2,936,534 D) $2,714,300 Ans: A Feedback: Cost of machinery = ¥278.45 million Forward rate = ¥105.46/$ Cost of equipment in dollars = ¥278,450,000 / ¥105.46/$ = $2,640,337.57 or $2,640,338

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 55. John Travers is planning a holiday to Thailand but is concerned that the U.S. dollar will decline in value before he makes his trip. His travel agent has planned a trip for him for a total cost of 41,250 Thai baht. John plans to purchase the bahts forward and is given a dollar estimate of $1,247.17 based on the 30-day forward quote. What is the forward rate? A) THB41.2500/$ B) THB33.0749/$ C) $0.0242/THB D) $1.2471/THB Ans: B Feedback: Cost of trip = THB 41,250 Cost of trip based on forward rate = $1,247.17 30-day forward quote = THB 41,250 / $1,247.17 = THB 33.0749/$

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 56. A local bank has requested foreign exchange quotes for the Swedish krona from Citibank. Citibank quotes a bid rate of $0.1652/SK and an ask rate of $0.1667/SK. What is the bid-ask spread? (Round your final percentage answer to one decimal place.) A) 1.2% B) 2.1% C) 0.9% D) 0.65% Ans: C Feedback:

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 57. A foreign exchange dealer is willing to buy the New Zealand dollar (NZ$) at $0.7621/NZ$ and will sell it at a rate of $0.7714/NZ$. What is the bid-ask spread on the Danish krone? (Round your final percentage answer to two decimal place places.) A) 0.26% B) 2.13% C) 0.96% D) 1.21% Ans: D Feedback:

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 58. Banco Herrero wants to make a bid-ask spread of 0.55 percent on its foreign exchange transactions. If the ask rate on the Mexican peso (MP) is MP10.4192/$, what does the bid rate have to be? (Do not round your intermediate calculation. Round your final answer to four decimal places.) A) MP10.3619/$ B) MP10.4192/$ C) MP10.4249/$ D) MP10.2165/$ Ans: A Feedback:

The ask rate will have to be MP10.3619/$ to provide a 0.55 percent bid-ask spread.

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 59. Bartman, Corp. observes that the Swiss franc (SF) is being quoted at $0.6164/SF, while the Swedish krona (SK) is quoted at $0.1981/SK. What is the SK/SF cross rate? (Round your final answer to four decimal places.) A) SK0.3214/SF B) SK3.1116/SF C) SK0.4183/SF D) SK2.1467/SF Ans: B Feedback: To find the SK/SF cross rate, divide the Swiss franc quote by the Swedish krona quote. Cross rate = $0.6164/SF / $0.1981/SK = SK3.1116/SF

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 60. Xecor Pharma just received revenues of A$2,372,300 in Australian dollars (A$). The only quotes management received are A$2.0651/£ and $1.8538/£. What is the U.S. dollar value of the company's revenues? (Do not round your intermediate calculation. Round your final answer to the nearest dollar.) A) $4,397,770 B) $4,899,037 C) $2,129,567 D) $9,081,834 Ans: C Feedback: Revenues received by Xecor Pharma = $2,372,300 To determine the A$ /$ cross rate, you divide the A$ to £ quote by the $/£ quote. Cross rate = A$2.0651/£ ÷ $1.8538/£ = A$1.1139820 U.S. dollar value of its revenue = A$2,372,300 / A$1.1140/$ = $2,129,567

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 61. Trident Corp. recently purchased machinery parts worth 23.5 million Mexican Pesos (MP). Management needs to find out the U.S. dollar cost of the payables. It has access to two quotes for Canadian dollars (C$): C$1.0774/$ and C$0.0981/MP. What will it cost Trident to purchase 23.5 million Mexican pesos? (Do not round your intermediate calculations. Round your final answer to the nearest dollar.) A) $2,531,890 B) $2,305,350 C) $2,139,735 D) $1,987,325 Ans: C Feedback: Foreign currency payables = MP 23.5 million To find the MP/$ quote, divide the C$/MP quote by the C$/$ quote. Cross rate = C$0.0981/MP / C$1.0774/$ = $0.091052534/MP Dollar cost of payables = MP23,500,000 × $0.0910525/MP = $2,139,735

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Medium Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 62. Dresdner Bank has offered the following exchange rate quotes on Indian rupees (Rs) Rs.83.7612/£ and $1.8654/£. What is the cross rate between the Indian rupees and the U.S. dollar?(Round your final answer to four decimal places) A) Rs.44.9025/$ B) Rs.49.9375/$ C) Rs.51.2134/$ D) Rs.36,7122/$ Ans: A Feedback: To find the Rs./$ cross rate, divide the Rs/£ quote by the $/£ quote. Cross rate = Rs.83.7612/£/ $1.8654/£= Rs.44.9025/$

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 63. The spot rate on the London market was £0.5434/$, while the 90-day forward rate was £0.5519/$. What is the annualized forward premium or discount on the U.S. dollar for the period? (Round your final answer to one decimal place.) A) 1.6% premium B) 6.3% premium C) 6.3% discount D) 1.6% discount Ans: B Feedback:

or 6.30% The British pound is at a forward discount of 6.3 percent against the U.S. dollar as it takes more pounds to buy a dollar at the forward rate. Or we can say that the U.S dollar is at a 90-day forward premium of 6.3 percent against the British pound.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 64. Bank of America quoted the 180-day forward rate on the Japanese yen at $0.009702/¥. The spot rate was quoted at $0.009466/¥. What is the forward premium or discount on the Japanese yen? (Round your final answer to the nearest percentage.) A) 7% premium B) 7% discount C) 5% premium D) 5% discount Ans: C Feedback:

or 5.00% The Japanese yen is at a 5 percent forward premium against the dollar.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 65. State Bank of India has offered a spot rate quote on Indian rupees (Rs.) of Rs. 42.47/$. The Indian rupee is quoted at a 30-day forward discount of 7.65 percent against the dollar. What is the 30-day forward quote? A) Rs.43.5622/$ B) Rs.41.5687/$ C) Rs.45.1226/$ D) Rs.42.7407/$ Ans: D Feedback: Spot rate = Rs.42.47/$ 30-day forward premium on the dollar = 7.65%

The 30-day forward rate is Rs.42.7407/$.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 66. Tamcon Industries has purchased equipment from a Brazilian firm for a total cost of 1,272,500 Brazilian reals (BR). The firm has to pay in 30 days. Citicorp has given the firm a 30-day forward quote of $0.6123/BR. Assume that on the day the payment is due, the spot rate is at $0.6317/BR. How much would Tamcon save by hedging with a forward contract? (Round your final answer to the nearest dollar.) A) $24,687 B) $803,838 C) $779,152 D) $31,278 Ans: A Feedback: Foreign currency payables = BR1,272,500 Spot rate on payment date = $0.6317/BR Dollar cost of payables = BR1,272,500 × $0.6317/BR = $803,838.25 30-day forward rate = $0.6123/BR Cost if hedged at forward rate = BR 1,272,500 × $0.6123/BR = $779,151.75 Cost savings = $803,838.25 − $779,151.75 = $24,686.50 or $24,687.00

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 67. Kapona Industries has purchased equipment from a Korean firm for a total cost of 11,500,000 Korean won. The firm has to pay in 90 days. J. P. Morgan has given the firm a 90-day forward quote of $0.0009791/won. Assume that on the day the payment is due, the spot rate is at $0.001004/ won. How much would Kapona save by hedging with a forward contract? (Round your final answer to the nearest dollar.) A) $687 B) $338 C) $152 D) $286 Ans: D Feedback: Foreign currency payables = 11,500,000 Korean won Spot rate on payment date = $0.001004/ won Dollar cost of payables = 11,500,000 won × $0.001004/ won= $11,546 30-day forward rate = $0.0009791/won Cost if hedged at forward rate = 11,500,000 won × $0.0009791/won= $11,259.65 Cost savings = $11,546.00 – $11,259.65 = $286.35 or $286.00

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 68. Carrington Industries sold equipment to a Mexican firm. Payment of 41,275,000 pesos will be due in 30 days. Carrington has the option of selling the pesos at a 30-day forward rate of $0.09739/peso. If it waits 30 days to sell the pesos, the expected spot rate is $0.09596/peso. How much additional dollar revenue will Carrington get by selling forward the pesos? (Round your final answer to the nearest dollar.) A) $24,687 B) $83,838 C) $59,023 D) $31,278 Ans: C Feedback: Foreign currency receivables = MP 41,275,000 Spot rate on payment date = $0.09596/peso Dollar revenues from receivables = MP 41,275,000 × $0.09596/peso = $3,960,749 30-day forward rate = $0.09739/peso Revenues if hedged at forward rate = MP 41,275,000 × $0.09739/peso = $ 4,019,772.25 Additional revenues received = $4,019,772.25 – $3,960,749 = $59,023.25 or $59,023

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 2 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 69. Palermo, Corp. sold equipment to a French firm. Payment of €4,275,000 will be due in 90 days. Palermo has the option of selling the euros at a 90-day forward rate of $1.5922/€. If it waits 90 days to sell the euros, the expected spot rate is $1.5645/€. How much dollar revenue will Palermo lose by not selling forward the euros? (Round your final answer to the nearest dollar.) A) $124,687 B) $118,418 C) $159,023 D) $131,278 Ans: B Feedback: Foreign currency receivables = €4,275,000 Spot rate on payment date = $1.5645/€ Dollar revenues from receivables = €4,275,000 × $1.5645/€ = $6,688,237.50 90-day forward rate = $1.5922/€ Revenues if hedged at forward rate = €4,275,000 × $1.5922/€ = $ 6,806,655 Additional revenues lost by not hedging = $6,688,237.50 − $ 6,806,655 = $118,417.50 or $118,418.00

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 70. When performing capital budgeting analysis on international projects, managers A) find it more difficult to estimate the incremental cash flows for foreign projects. B) have to deal with foreign exchange rate risk on international capital investments. C) must incorporate a country risk premium when evaluating foreign business activities. D) All of these Ans: D

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 71. The ways that a foreign government can affect the risk of a foreign project include A) change tax laws in a way that adversely impacts the firm. B) impose laws related to labor, wages, and prices that are more restrictive than those applicable for domestic firms. C) disallow any remittance of funds from the subsidiary to the parent firm for either a limited period of time or the duration of the project. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 72. The ways that a foreign government can adversely affect the risk of a foreign project include all EXCEPT A) change tax laws in a way that adversely impacts the firm. B) impose laws related to labor, wages, and prices that are more restrictive than those applicable for domestic firms. C) remove tariffs and quotas on any imports. D) disallow any remittance of funds from the subsidiary to the parent firm for either a limited period of time or the duration of the project. Ans: C

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Fundamentals of Corporate Finance 3e

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Format: Multiple Choice Learning Objective: LO 3 Level of Difficulty: Easy Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 73. Country risk should be incorporated into the international capital budgeting analysis by A) adjusting the firm's discount rate for the additional risk. B) increasing cash flow estimates from the project. C) including the country risk premium to sunk costs. D) None of these Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 74. The Euromarkets are A) vast, largely unregulated money and capital markets existing in Tokyo, Hong Kong, and Singapore. B) vast, regulated money and capital markets with major financial centers in the United Kingdom. C) vast, regulated money and capital markets with major financial centers in the euro zone. D) None of these Ans: A

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 75. The Eurocurrency market is the A) medium-term portion of the Euromarket. B) short-term portion of the Euromarket. C) long-term portion of the Euromarket. D) None of these Ans: B

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 76. Which of the following statements about Eurocredits is true? A) The international banking system gathers funds from businesses and governments in the Eurocurrency market and then allocates funds to banks that have the most profitable lending opportunities. B) Eurocredits are denominated in all major Eurocurrencies, although the dollar is the overwhelming favorite. C) Eurocredits are short- to medium-term loans made to multinational corporations and governments of medium to high credit quality. D) All of these Ans: D

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 77. Long-term debt sold by a foreign firm to investors in a foreign country and denominated in that country's currency is called a _____ . A) Eurobond B) municipal bond C) foreign bond D) currency bond Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Knowledge AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 78. Long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated are called _____. A) Samurai bonds B) Eurobonds C) foreign bonds D) currency bonds Ans: B

Format: Multiple Choice Learning Objective: LO 4 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 79. Which of the following statements about Eurobonds is NOT true? A) Multinational firms can use Eurobonds to finance international or domestic projects. B) Eurobonds are bearer bonds. C) Eurobonds are bonds that have to be registered. D) Eurobonds also pay interest annually. Ans: C

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Multiple Choice Learning Objective: LO 5 Level of Difficulty: Hard Bloomcode: Application AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 80. Zylex Corporation's German unit is looking to borrow €4.5 million from Deutsche Bank. Deutsche Bank quotes a rate of three-month LIBOR plus 0.5 percent for the 90-day loan. Currently, the three-month LIBOR is 4.175 percent. If the exchange rate on the payoff date is €0.8334/$, what is the dollar cost of the loan? (Round your final answer to two decimal places.) A) $63,107.45 B) $126,214.90 C) $39,143.76 D) $56,357.99 Ans: A Feedback: Amount Zylex plans to borrow = €4.5 million Term of loan = 90 days Interest cost = LIBOR + 0.5% = 4.175 % + 0.5% = 4.675% Interest cost in euros = €4,500,000 × 0.04675 × (90/360) = €52,593.75 Spot rate on payoff date = €0.8334/$ Dollar interest cost = €52,593.75 / €0.8334/$ = $63,107.45

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level Of Difficulty: Medium Bloomcode: Comprehension AASCB: Analytic IMA: Global Business AICPA: Industry/Global Perspective 81. What are the six factors that can cause international business transactions to differ from domestic deals? Ans: The six factors are foreign exchange risk, differences in legal systems and tax codes, the divergence of the language for communication purposes in business and socialization, cultural differences, differences in economic systems, and country risk. These six factors can cause international business transactions to differ from domestic deals. The uncertainty of future exchange rate movements is called foreign exchange rate risk, or just exchange rate risk. Differences in legal systems and tax codes can also impact the way firms operate in foreign countries. There are two important levels of communication in international business deals: business communication and social communication. Although English is the official business language, it is not the world's social language. Cultural views also shape business practices and people's attitudes toward business. An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed. Country risk refers to political uncertainty associated with a particular country and hence, its impact on a firm's cash flows.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 1 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 82. How does the goal of a firm vary across countries? Ans: Stockholder wealth maximization is the accepted goal for firms in the United States, as well as in some other countries that share a similar heritage, such as the United Kingdom, Australia, India, and Canada. In Continental Europe, for example, countries such as France and Germany focus on maximizing corporate wealth. The European manager's goal is to earn as much wealth as possible for a firm while considering the overall welfare of all stakeholders. In Japan, companies form tightly knit, interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, and the goal of a Japanese business manager is to increase the wealth and growth of the keiretsu. As a result, he might focus on maximizing market share rather than stockholder wealth. In China, which is making a transition from a command economy to a market-based economy, there are sharp differences between state-owned companies and emerging private-sector firms. The large state-owned companies have an overall goal that can best be described as maintaining full employment in the economy while the new privatesector firms fully embrace the Western standard of stockholder wealth maximization.

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Fundamentals of Corporate Finance 3e

Test Bank

Format: Essay Learning Objective: LO 5 Level of Difficulty: Medium Bloomcode: Comprehension AASCB: Diversity IMA: Global Business AICPA: Industry/Global Perspective 83. Describe the global debt markets. Ans: The international debt markets can be classified into the Eurocurrency market, the Eurocredit market, and the long-term bond market. The Eurocurrency market is the short-term portion of the Euromarket. The most widely quoted Eurocurrency interest rate is the London Interbank Offer Rate, or LIBOR, which is the short-term interest rate that major banks in London charge one another. The international banking system gathers funds from businesses and governments in the Eurocurrency market and then allocates funds to banks that have the most profitable lending opportunities. These loans, which are short- to medium-term loans of a Eurocurrency to multinational corporations and governments of medium to high credit quality, are called Eurocredits. Eurocredits are denominated in all major Eurocurrencies, although the dollar is the overwhelming favorite. International bonds fall into two generic categories: foreign bonds and Eurobonds. Foreign bonds are long-term debt sold by a foreign firm to investors in another country and denominated in that country's currency. Foreign bonds may have colorful nicknames: foreign bonds sold in the United States are called Yankee bonds, and yendenominated bonds sold in Japanese financial markets by non-Japanese firms are called Samurai bonds. Firms sell foreign bonds when they need to finance projects in a particular foreign country. Eurobonds are long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated. Multinational firms can use Eurobonds to finance international or domestic projects. Eurodollar and other Eurocurrency bonds have a number of characteristics that differ from similar U.S corporate bonds. Eurobonds are bearer bonds and do not have to be registered. Eurobonds also pay interest annually. While historically almost all Eurocurrency bonds were sold without credit ratings, today, more than half of the Eurodollar bonds sold in Europe have credit ratings.

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