Fundamentals of Corporate Finance 9th Edition by Ace Test Banks

Fundamentals of Corporate Finance 9th Edition

By Richard Brealey and Stewart Myers and Alan Marcus

Chapter 01 Test Bank - Static Student: ___________________________________________________________________________

The liability of sole proprietors is limited to the amount of their investment in the company. True

General partners have limited personal liability for business debts in a limited partnership. True

False

Facebook's decision to spend $700 million to acquire Instagram is an investment decision. True

False

A successful investment is one that increases the value of the firm. True

False

Capital budgeting decisions are used to determine how to raise the cash necessary for investments. True

False

Financial assets have value because they are claims on the firm's real assets and the cash that those assets will produce. True

False

A major disadvantage of partnerships is that they have double taxation of profits. True

False

The separation of ownership and management is one distinctive feature of corporations. True

False

Boards of directors are generally appointed by the firm's senior officers. True

False

10. Financial analysts are involved in monitoring the risk associated with investment projects and financing decisions. True

False

11. The primary goal of any company should be to maximize current period profits. True

False

12. Maximizing profits is the same as maximizing the value of the firm. True

False

13. The Dodd-Frank financial reform law in 2010 granted shareholders a binding vote on executive compensation. True

False

14. Sole proprietorships face the same agency problems as those associated with corporations. True

False

15. Real assets can be intangible assets. True

False

16. Making good investment and financing decisions is the chief task of the financial manager. True

False

17. If a project's value is less than its required investment, then the project is financially attractive. True

False

18. GlaxoSmithKline's spending of $6 billion in 2012 on research and development of new drugs is a capital budgeting decision but not a financing decision. True

False

19. Volkswagen's issuance of a 2.5 billion euro convertible bond is a financing decision. True

False

20. An IOU ("I owe you") from your brother-in-law is a financial asset. True

False

21. The separation of ownership and management is one distinctive feature of both corporations and sole proprietors. True

False

22. Shareholders welcome higher short-term profits even when they damage long-term profits. True

False

23. A well-designed compensation package can help a firm achieve its goal of maximizing market value. True

False

24. While control of large public companies in the United States is exercised through the board of directors and pressure from the stock market, in many other countries the stock market is less important and control shifts to major stockholders, typically banks and other companies. True

False

25. Established firms can create value by developing long-term relationships and maintaining a good reputation. True

False

26. Which one of these is a disadvantage of the corporate form of business? A. Access to capital B. Unlimited personal liability for owners C. Limited firm life D. Legal requirements 27. Which one of the following gives a corporation its permanence? A. Multiple owners B. Limited liability C. Corporation taxation D. Separation of ownership and control 28. In a partnership form of organization, income tax liability, if any, is incurred by: A. the partnership itself. B. the partners individually. C. both the partnership and the partners. D. neither the partnership nor the partners. 29. Which one of the following would correctly differentiate general partners from limited partners in a limited partnership? A. General partners have more job experience. B. General partners have an ownership interest. C. General partners are subject to double taxation. D. General partners have unlimited personal liability. 30. Which form of organization provides limited liability for the firm but yet allows the professionals working within that firm to be sued personally? A. Limited liability partnership B. Limited liability company C. Sole proprietorship D. Professional corporation 31. Which of the following is least likely to be discussed in the articles of incorporation? A. How the firm is to be financed B. The purpose of the business C. The price range of the shares of stock D. How the board of directors is to be structured 32. When a corporation fails, the maximum that can be lost by an individual shareholder is: A. the amount of their initial investment. B. the amount of their share of the profits. C. their proportionate share required to pay the corporation's debts. D. the amount of their personal wealth.

33. Which of the following is a disadvantage to incorporating a business? A. Easier access to financial markets B. Limited liability C. Becoming a permanent legal entity D. Profits taxed at the corporate level and the shareholder level 34. Unlimited liability is faced by the owners of: A. corporations. B. partnerships and corporations. C. sole proprietorships and general partnerships. D. all forms of business organization. 35. Which one of these statements correctly applies to a limited partnership? A. All partners share the daily management duties. B. All partners enjoy limited personal liability. C. General partners have unlimited personal liability. D. Taxes are imposed at both the firm and the personal level on profits earned. 36. In the case of a limited liability partnership, ________ has/have limited liability. A. only some of partners B. only the managing partner C. all of the partners D. none of the partners 37. A board of directors is elected as a representative of the corporation's: A. top management. B. stakeholders. C. shareholders. D. customers. 38. The legal "life" of a corporation is: A. coincidental with that of its CEO. B. equal to the life of its board of directors. C. permanent, as long as shareholders don't change. D. permanent, regardless of current ownership. 39. When the management of a business is conducted by individuals other than the owners, the business is most likely to be a: A. corporation. B. sole proprietorship. C. partnership. D. general partner.

40. "Double taxation" refers to: A. all partners paying equal taxes on profits. B. corporations paying taxes on both dividends and retained earnings. C. paying taxes on profits at the corporate level and dividends at the personal level. D. the fact that marginal tax rates are doubled for corporations. 41. A corporation is considered to be closely held when: A. only a few shareholders exist. B. the market value of the shares is stable. C. it operates in a small geographic area. D. management also serves as the board of directors. 42. Corporations are referred to as public companies when their: A. shareholders have no tax liability. B. shares are held by the federal or state government. C. stock is publicly traded. D. products or services are available to the public. 43. A common problem for closely held corporations is: A. the lack of access to substantial amounts of capital. B. the restriction that shareholders receive only one vote each. C. the separation of ownership and management. D. an abundance of agency problems. 44. Corporate managers are expected to make corporate decisions that are in the best interest of: A. top corporate management. B. the corporation's board of directors. C. the corporation's shareholders. D. all corporate employees. 45. Which one of the following is a financial asset? A. A corporate bond B. A machine C. A patent D. A factory 46. Which of the following statements best distinguishes the difference between real and financial assets? A. Real assets have less value than financial assets. B. Real assets are tangible; financial assets are not. C. Financial assets represent claims to income that is generated by real assets. D. Financial assets appreciate in value; real assets depreciate in value.

47. Which one of the following is a real asset? A. A patent B. A personal IOU C. A checking account balance D. A share of stock 48. Which one of these is not considered to be a security? A. Shares of GE stock B. A bond traded in the financial market C. A mortgage loan issued and held by a bank D. A convertible bond issued to the public 49. Corporations that issue financial securities such as stock or debt obligations to the public do so primarily to: A. increase sales. B. become profitable. C. increase their access to funds. D. avoid double taxation of their profits. 50. Which one of the following would be considered a capital budgeting decision? A. Planning to issue common stock rather than issuing preferred stock B. Deciding to expand into a new line of products, at a cost of $5 million C. Repurchasing shares of common stock D. Issuing debt in the form of long-term bonds 51. Which one of these is a capital budgeting decision? A. Deciding between issuing stock or debt securities B. Deciding whether or not the firm should go public C. Deciding if the firm should repurchase some of its outstanding shares D. Deciding whether to buy a new machine or repair the old machine 52. The best criterion for success in a capital budgeting decision would be to: A. minimize the cost of the investment. B. maximize the number of capital budgeting projects. C. maximize the value added to the firm. D. finance all capital budgeting projects with debt. 53. The overall goal of capital budgeting projects should be to: A. decrease the firm's reliance on debt. B. increase the firm's sales. C. increase the firm's outstanding shares of stock. D. increase the wealth of the firm's shareholders.

54. An example of a firm's financing decision would be: A. acquiring a competitive firm. B. determining how much to pay for a specific asset. C. issuing 10-year versus 20-year bonds. D. deciding whether or not to increase the price of its products. 55. Which of the following is a capital budgeting decision? A. Should the firm borrow money from a bank or sell bonds? B. Should the firm shut down an unprofitable factory? C. Should the firm buy or lease a new machine that it is committed to acquiring? D. Should the firm issue preferred stock or common stock? 56. Which of these duties are responsibilities of the corporate treasurer? A. Financial statements and taxes B. Cash management and tax reporting C. Cash management and banking relationships D. Raising capital and financial statements 57. The term "capital structure" refers to: A. the mix of long-term debt and equity financing. B. the length of time needed to repay debt. C. whether or not the firm invests in capital budgeting projects. D. the types of assets a firm acquires. 58. Firms can alter their capital structure by: A. not accepting any new capital budgeting projects. B. investing in intangible assets. C. issuing stock to repay debt. D. becoming a limited liability company. 59. Which one of these statements is correct? A. Financial managers have a fiduciary duty to stockholders. B. Financial managers are concerned only with funds that flow to investors. C. The chief financial officer generally reports directly to the corporate treasurer. D. The corporate controller is primarily responsible for overseeing a firm's cash functions. 60. A firm decides to pay for a small investment project through a $1 million increase in short-term bank loans. This is best described as an example of a(n): A. financing decision. B. investment decision. C. capital budgeting decision. D. capital expenditure decision.

61. The short-term decisions of financial managers are comprised of: A. capital structure decisions only. B. investment decisions only. C. financing decisions only. D. both investment and financing decisions. 62. A block holder is commonly defined as an investor who: A. owns 5 percent or more of a firm's outstanding shares. B. invests in more than one firm within the same industry. C. is another corporation. D. is also one of the firm's managers or directors. 63. Which of the firm's financial managers is most likely to be involved with obtaining financing for the firm? A. Treasurer B. Controller C. Chief Operating Officer D. Board of directors 64. In a large corporation, preparation of the firm’s financial statements would most likely be conducted by the: A. treasurer. B. controller. C. chief financial officer. D. financial manager. 65. In a firm having both a treasurer and a controller, which of the following would most likely be handled by the controller? A. Internal auditing B. Credit management C. Banking relationships D. Insurance 66. Which one of the following statements more accurately describes the controller than the treasurer? A. Reports directly to the chief executive officer B. Monitors capital expenditures to make sure that they are not misappropriated C. Responsible for investing the firm's spare cash D. Responsible for arranging any issue of common stock 67. A chief financial officer would typically: A. report to the treasurer, but supervise the controller. B. report to the controller, but supervise the treasurer. C. report to both the treasurer and controller. D. supervise both the treasurer and controller.

68. Which one of these determines the minimum acceptable rate of return on a capital investment? A. The alternative investment opportunities available to investors B. The profit margin of the existing firm C. The rate of return on the firm's outstanding shares D. The rate of return on risk-free debt securities 69. A financial analyst in a corporation may be involved with all of the following EXCEPT: A. analyzing a new investment project. B. monitoring risk. C. managing investment of the company's cash. D. purchasing the firm's plant and equipment. 70. Investment banks like Morgan Stanley or Goldman Sachs: A. collect deposits and relend the cash to corporations and individuals. B. help companies sell their securities to investors. C. design and sell insurance policies for businesses. D. lend to corporations and investors in commercial real estate. 71. The primary goal of corporate management should be to: A. maximize the number of shareholders. B. maximize the firm's profits. C. minimize the firm's costs. D. maximize the shareholders' wealth. 72. A corporate board of directors should provide support for the top management team: A. under all circumstances. B. in all decisions related to cash dividends. C. only when the board approves of management's actions. D. if shareholders are pleased with the firm's performance. 73. Which of the following appears to be the most appropriate goal for corporate management? A. Maximizing market value of the company's shares B. Maximizing the company's market share C. Maximizing the current profits of the company D. Minimizing the company's liabilities 74. A firm with spare cash A. should always reinvest it in new equipment. B. should pay it out to shareholders unless the firm can earn a higher rate of return on the cash than the shareholders can earn by investing in the capital market. C. should invest it in the safest projects available. D. Should always invest it in U.S. equities.

75. Financial managers should only accept investment projects that: A. increase the current profits of the firm. B. can increase the firm's market share. C. earn a higher rate of return than the firm currently earns on its existing projects. D. earn a higher rate of return than shareholders can get by investing on their own. 76. Agency problems can least be controlled by: A. establishing good internal controls and procedures. B. designing compensation packages that align manager's goals with those of the shareholders. C. good systems of corporate governance. D. electing senior managers to the board of directors. 77. Which one of these best defines the objective of a well-functioning financial market? A. Establishing accurate security prices B. Creating higher security prices C. Eliminating short-selling profits D. Increasing shareholder value by any means possible 78. Corporate raiders will be looked upon most favorably if they: A. divide up large profitable entities. B. take actions that increase current shareholder wealth. C. create value for themselves through their actions. D. change the capital structure of a firm by increasing its debt. 79. Ethical decision making by management has a payoff for shareholders in terms of: A. improved capital structure. B. enhanced firm reputation value. C. increased managerial benefits. D. higher current dividend payments. 80. Ethical decision making in business: A. reduces the firm's profits. B. requires adherence to implied rules as well as written rules. C. is not in the best interests of shareholders. D. is less important than good capital budgeting decisions. 81. A corporate director: A. is selected by and can be removed by management. B. can be voted out of power by the shareholders. C. has a lifetime appointment to the board. D. is selected by a vote of all corporate stakeholders.

82. In which of the following organizations would agency problems be least likely to occur? A. A sole proprietorship B. A partnership C. A corporation D. A closely held corporation 83. Sole proprietorships resolve the issue of agency problems primarily by: A. avoiding excessive expense accounts. B. discharging those who violate the rules. C. allowing owners to share the cost of their actions with others. D. forcing owners to bear the full cost of their actions. 84. Which one of the following can best be characterized as an agency problem? A. differing opinions among directors as to the merits of paying a higher dividend. . B. differing incentives between managers and owners. C. persistently late delivery times by a major supplier. D. Geological problems in the company’s new gold mine. 85. Which of the following is least likely to represent an agency problem? A. Lavish spending on expense accounts B. Plush remodelling of the executive suite C. Excessive avoidance of taxes D. Executive incentive compensation plans 86. When managers' compensation plans are tied in a meaningful manner to the value of the firm, agency problems: A. can be reduced. B. will be created. C. are shifted to other stakeholders. D. are eliminated entirely from the firm. 87. A firm's reputation: A. has no value. B. is an important firm asset. C. is irrelevant to shareholders. D. can be easily restored once damaged. 88. Which of the following groups is least likely to be considered a stakeholder of the firm? A. Government B. Customers C. Competitors D. Employees

89. A manager's compensation plan that offers financial incentives for increases in quarterly profitability may create agency problems in that: A. the managers are not motivated by personal gain. B. the board of directors may claim the credit. C. short-term, not long-term profits become the focus. D. investors desire stable profits. 90. One continuing problem with managerial incentive compensation plans is that: A. the plans increase agency problems. B. managers prefer guaranteed salaries. C. their effectiveness is difficult to evaluate. D. the plans do not reward shareholders. 91. Which one of the following forms of compensation is most apt to align the interests of managers and shareholders? A. A fixed salary B. A salary that is linked to current company profits C. A salary that is paid partly in the form of the company's shares D. A salary that is linked to the company's market share 92. Which of the following is a real asset? A. A patent B. A share of stock issued by Bank of New York C. An IOU ("I owe you") from your brother-in-law D. A mortgage loan taken out to help pay for a new home 93. Which one of these statements is correct? A. A dollar received next year has the same value as a dollar received today. B. Risky cash flows are more valuable than certain cash flows. C. Smart investment decisions create more value than smart financing decisions. D. Corporate governance is irrelevant. 94. Short selling involves selling a security: A. you do not own. B. that you have owned for less than one year. C. at a price below current market value. D. for less than you originally paid to purchase it.

Chapter 01 Test Bank - Static Key 1.

The liability of sole proprietors is limited to the amount of their investment in the company. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

General partners have limited personal liability for business debts in a limited partnership. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

The separation of ownership and management is one distinctive feature of corporations. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

A major disadvantage of partnerships is that they have double taxation of profits. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

Financial assets have value because they are claims on the firm's real assets and the cash that those assets will produce. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy

Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

Capital budgeting decisions are used to determine how to raise the cash necessary for investments. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

A successful investment is one that increases the value of the firm. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Goal of financial management

Facebook's decision to spend $700 million to acquire Instagram is an investment decision. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

Boards of directors are generally appointed by the firm's senior officers. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Management organization and roles

10.

Financial analysts are involved in monitoring the risk associated with investment projects and financing decisions. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

11.

The primary goal of any company should be to maximize current period profits. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

12.

Maximizing profits is the same as maximizing the value of the firm. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

13.

The Dodd-Frank financial reform law in 2010 granted shareholders a binding vote on executive compensation. FALSE AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Ethics, governance, and regulation

14.

Sole proprietorships face the same agency problems as those associated with corporations. FALSE AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

15.

Real assets can be intangible assets. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

16.

Making good investment and financing decisions is the chief task of the financial manager. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Management organization and roles

17.

If a project's value is less than its required investment, then the project is financially attractive. FALSE AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Goal of financial management

18.

GlaxoSmithKline's spending of $6 billion in 2012 on research and development of new drugs is a capital budgeting decision but not a financing decision. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

19.

Volkswagen's issuance of a 2.5 billion euro convertible bond is a financing decision. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

20.

An IOU ("I owe you") from your brother-in-law is a financial asset. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

21.

The separation of ownership and management is one distinctive feature of both corporations and sole proprietors. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

22.

Shareholders welcome higher short-term profits even when they damage long-term profits. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

23.

A well-designed compensation package can help a firm achieve its goal of maximizing market value. TRUE AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

24.

While control of large public companies in the United States is exercised through the board of directors and pressure from the stock market, in many other countries the stock market is less important and control shifts to major stockholders, typically banks and other companies. TRUE AACSB: Diversity Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Management organization and roles

25.

Established firms can create value by developing long-term relationships and maintaining a good reputation. TRUE AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Goal of financial management

26.

Which one of these is a disadvantage of the corporate form of business? A. Access to capital B. Unlimited personal liability for owners C. Limited firm life D. Legal requirements AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

27.

Which one of the following gives a corporation its permanence? A. Multiple owners B. Limited liability C. Corporation taxation D. Separation of ownership and control AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

28.

In a partnership form of organization, income tax liability, if any, is incurred by: A. the partnership itself. B. the partners individually. C. both the partnership and the partners. D. neither the partnership nor the partners. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

29.

Which one of the following would correctly differentiate general partners from limited partners in a limited partnership? A. General partners have more job experience. B. General partners have an ownership interest. C. General partners are subject to double taxation. D. General partners have unlimited personal liability. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

30.

Which form of organization provides limited liability for the firm but yet allows the professionals working within that firm to be sued personally? A. Limited liability partnership B. Limited liability company C. Sole proprietorship D. Professional corporation AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

31.

Which of the following is least likely to be discussed in the articles of incorporation? A. How the firm is to be financed B. The purpose of the business C. The price range of the shares of stock D. How the board of directors is to be structured AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

32.

When a corporation fails, the maximum that can be lost by an individual shareholder is: A. the amount of their initial investment. B. the amount of their share of the profits. C. their proportionate share required to pay the corporation's debts. D. the amount of their personal wealth. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

33.

Which of the following is a disadvantage to incorporating a business? A. Easier access to financial markets B. Limited liability C. Becoming a permanent legal entity D. Profits taxed at the corporate level and the shareholder level AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy

Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

34.

Unlimited liability is faced by the owners of: A. corporations. B. partnerships and corporations. C. sole proprietorships and general partnerships. D. all forms of business organization. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

35.

Which one of these statements correctly applies to a limited partnership? A. All partners share the daily management duties. B. All partners enjoy limited personal liability. C. General partners have unlimited personal liability. D. Taxes are imposed at both the firm and the personal level on profits earned. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

36.

In the case of a limited liability partnership, ________ has/have limited liability. A. only some of partners B. only the managing partner C. all of the partners D. none of the partners AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

37.

A board of directors is elected as a representative of the corporation's: A. top management. B. stakeholders. C. shareholders. D. customers. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Management organization and roles

38.

The legal "life" of a corporation is: A. coincidental with that of its CEO. B. equal to the life of its board of directors. C. permanent, as long as shareholders don't change. D. permanent, regardless of current ownership. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

39.

When the management of a business is conducted by individuals other than the owners, the business is most likely to be a: A. corporation. B. sole proprietorship. C. partnership. D. general partner. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

40.

"Double taxation" refers to: A. all partners paying equal taxes on profits. B. corporations paying taxes on both dividends and retained earnings. C. paying taxes on profits at the corporate level and dividends at the personal level. D. the fact that marginal tax rates are doubled for corporations. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

41.

A corporation is considered to be closely held when: A. only a few shareholders exist. B. the market value of the shares is stable. C. it operates in a small geographic area. D. management also serves as the board of directors. AACSB: Communication Accessibility: Keyboard Navigation

Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

42.

Corporations are referred to as public companies when their: A. shareholders have no tax liability. B. shares are held by the federal or state government. C. stock is publicly traded. D. products or services are available to the public. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

43.

A common problem for closely held corporations is: A. the lack of access to substantial amounts of capital. B. the restriction that shareholders receive only one vote each. C. the separation of ownership and management. D. an abundance of agency problems. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

44.

Corporate managers are expected to make corporate decisions that are in the best interest of: A. top corporate management. B. the corporation's board of directors. C. the corporation's shareholders. D. all corporate employees. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

45.

Which one of the following is a financial asset? A. A corporate bond B. A machine C. A patent D. A factory AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

46.

Which of the following statements best distinguishes the difference between real and financial assets? A. Real assets have less value than financial assets. B. Real assets are tangible; financial assets are not. C. Financial assets represent claims to income that is generated by real assets. D. Financial assets appreciate in value; real assets depreciate in value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

47.

Which one of the following is a real asset? A. A patent B. A personal IOU C. A checking account balance D. A share of stock AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

48.

Which one of these is not considered to be a security? A. Shares of GE stock B. A bond traded in the financial market C. A mortgage loan issued and held by a bank D. A convertible bond issued to the public AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

49.

Corporations that issue financial securities such as stock or debt obligations to the public do so primarily to: A. increase sales. B. become profitable. C. increase their access to funds. D. avoid double taxation of their profits. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Forms of business organization

50.

Which one of the following would be considered a capital budgeting decision? A. Planning to issue common stock rather than issuing preferred stock B. Deciding to expand into a new line of products, at a cost of $5 million C. Repurchasing shares of common stock D. Issuing debt in the form of long-term bonds AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

51.

Which one of these is a capital budgeting decision? A. Deciding between issuing stock or debt securities B. Deciding whether or not the firm should go public C. Deciding if the firm should repurchase some of its outstanding shares D. Deciding whether to buy a new machine or repair the old machine AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

52.

The best criterion for success in a capital budgeting decision would be to: A. minimize the cost of the investment. B. maximize the number of capital budgeting projects. C. maximize the value added to the firm. D. finance all capital budgeting projects with debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Goal of financial management

53.

The overall goal of capital budgeting projects should be to: A. decrease the firm's reliance on debt. B. increase the firm's sales. C. increase the firm's outstanding shares of stock. D. increase the wealth of the firm's shareholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Goal of financial management

54.

An example of a firm's financing decision would be: A. acquiring a competitive firm. B. determining how much to pay for a specific asset. C. issuing 10-year versus 20-year bonds. D. deciding whether or not to increase the price of its products. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

55.

Which of the following is a capital budgeting decision? A. Should the firm borrow money from a bank or sell bonds? B. Should the firm shut down an unprofitable factory? C. Should the firm buy or lease a new machine that it is committed to acquiring? D. Should the firm issue preferred stock or common stock? AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

56.

Which of these duties are responsibilities of the corporate treasurer? A. Financial statements and taxes B. Cash management and tax reporting C. Cash management and banking relationships D. Raising capital and financial statements AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller.

Topic: Management organization and roles

57.

The term "capital structure" refers to: A. the mix of long-term debt and equity financing. B. the length of time needed to repay debt. C. whether or not the firm invests in capital budgeting projects. D. the types of assets a firm acquires. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Capital structure

58.

Firms can alter their capital structure by: A. not accepting any new capital budgeting projects. B. investing in intangible assets. C. issuing stock to repay debt. D. becoming a limited liability company. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Capital structure

59.

Which one of these statements is correct? A. Financial managers have a fiduciary duty to stockholders. B. Financial managers are concerned only with funds that flow to investors. C. The chief financial officer generally reports directly to the corporate treasurer. D. The corporate controller is primarily responsible for overseeing a firm's cash functions. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

60.

A firm decides to pay for a small investment project through a $1 million increase in short-term bank loans. This is best described as an example of a(n): A. financing decision. B. investment decision. C. capital budgeting decision. D. capital expenditure decision. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy

Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

61.

The short-term decisions of financial managers are comprised of: A. capital structure decisions only. B. investment decisions only. C. financing decisions only. D. both investment and financing decisions. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Financial management decisions

62.

A block holder is commonly defined as an investor who: A. owns 5 percent or more of a firm's outstanding shares. B. invests in more than one firm within the same industry. C. is another corporation. D. is also one of the firm's managers or directors. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation. Topic: Forms of business organization

63.

Which of the firm's financial managers is most likely to be involved with obtaining financing for the firm? A. Treasurer B. Controller C. Chief Operating Officer D. Board of directors AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

64.

In a large corporation, preparation of the firm’s financial statements would most likely be conducted by the: A. treasurer. B. controller. C. chief financial officer. D. financial manager. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember

Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

65.

In a firm having both a treasurer and a controller, which of the following would most likely be handled by the controller? A. Internal auditing B. Credit management C. Banking relationships D. Insurance AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

66.

Which one of the following statements more accurately describes the controller than the treasurer? A. Reports directly to the chief executive officer B. Monitors capital expenditures to make sure that they are not misappropriated C. Responsible for investing the firm's spare cash D. Responsible for arranging any issue of common stock AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

67.

A chief financial officer would typically: A. report to the treasurer, but supervise the controller. B. report to the controller, but supervise the treasurer. C. report to both the treasurer and controller. D. supervise both the treasurer and controller. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

68.

Which one of these determines the minimum acceptable rate of return on a capital investment? A. The alternative investment opportunities available to investors B. The profit margin of the existing firm C. The rate of return on the firm's outstanding shares D. The rate of return on risk-free debt securities AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Introduction to corporate finance

69.

A financial analyst in a corporation may be involved with all of the following EXCEPT: A. analyzing a new investment project. B. monitoring risk. C. managing investment of the company's cash. D. purchasing the firm's plant and equipment. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Management organization and roles

70.

Investment banks like Morgan Stanley or Goldman Sachs: A. collect deposits and relend the cash to corporations and individuals. B. help companies sell their securities to investors. C. design and sell insurance policies for businesses. D. lend to corporations and investors in commercial real estate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller. Topic: Introduction to corporate finance

71.

The primary goal of corporate management should be to: A. maximize the number of shareholders. B. maximize the firm's profits. C. minimize the firm's costs. D. maximize the shareholders' wealth. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

72.

A corporate board of directors should provide support for the top management team: A. under all circumstances. B. in all decisions related to cash dividends. C. only when the board approves of management's actions. D. if shareholders are pleased with the firm's performance. AACSB: Ethics

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Topic: Management organization and roles

73.

Which of the following appears to be the most appropriate goal for corporate management? A. Maximizing market value of the company's shares B. Maximizing the company's market share C. Maximizing the current profits of the company D. Minimizing the company's liabilities AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

74.

A firm with spare cash A. should always reinvest it in new equipment. B. should pay it out to shareholders unless the firm can earn a higher rate of return on the cash than the shareholders can earn by investing in the capital market. C. should invest it in the safest projects available. D. Should always invest it in U.S. equities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

75.

Financial managers should only accept investment projects that: A. increase the current profits of the firm. B. can increase the firm's market share. C. earn a higher rate of return than the firm currently earns on its existing projects. D. earn a higher rate of return than shareholders can get by investing on their own. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation. Topic: Goal of financial management

76.

Agency problems can least be controlled by: A. establishing good internal controls and procedures. B. designing compensation packages that align manager's goals with those of the shareholders. C. good systems of corporate governance. D. electing senior managers to the board of directors. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

77.

Which one of these best defines the objective of a well-functioning financial market? A. Establishing accurate security prices B. Creating higher security prices C. Eliminating short-selling profits D. Increasing shareholder value by any means possible AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Introduction to corporate finance

78.

Corporate raiders will be looked upon most favorably if they: A. divide up large profitable entities. B. take actions that increase current shareholder wealth. C. create value for themselves through their actions. D. change the capital structure of a firm by increasing its debt. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Topic: Goal of financial management

79.

Ethical decision making by management has a payoff for shareholders in terms of: A. improved capital structure. B. enhanced firm reputation value. C. increased managerial benefits. D. higher current dividend payments. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Topic: Goal of financial management

80.

Ethical decision making in business: A. reduces the firm's profits. B. requires adherence to implied rules as well as written rules. C. is not in the best interests of shareholders. D. is less important than good capital budgeting decisions. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Topic: Ethics, governance, and regulation

81.

A corporate director: A. is selected by and can be removed by management. B. can be voted out of power by the shareholders. C. has a lifetime appointment to the board. D. is selected by a vote of all corporate stakeholders. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Management organization and roles

82.

In which of the following organizations would agency problems be least likely to occur? A. A sole proprietorship B. A partnership C. A corporation D. A closely held corporation AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

83.

Sole proprietorships resolve the issue of agency problems primarily by: A. avoiding excessive expense accounts. B. discharging those who violate the rules. C. allowing owners to share the cost of their actions with others. D. forcing owners to bear the full cost of their actions. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems.

Topic: Agency costs and problems

84.

Which one of the following can best be characterized as an agency problem? A. differing opinions among directors as to the merits of paying a higher dividend. . B. differing incentives between managers and owners. C. persistently late delivery times by a major supplier. D. Geological problems in the company’s new gold mine. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

85.

Which of the following is least likely to represent an agency problem? A. Lavish spending on expense accounts B. Plush remodelling of the executive suite C. Excessive avoidance of taxes D. Executive incentive compensation plans AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

86.

When managers' compensation plans are tied in a meaningful manner to the value of the firm, agency problems: A. can be reduced. B. will be created. C. are shifted to other stakeholders. D. are eliminated entirely from the firm. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

87.

A firm's reputation: A. has no value. B. is an important firm asset. C. is irrelevant to shareholders. D. can be easily restored once damaged. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Topic: Goal of financial management

88.

Which of the following groups is least likely to be considered a stakeholder of the firm? A. Government B. Customers C. Competitors D. Employees AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Forms of business organization

89.

A manager's compensation plan that offers financial incentives for increases in quarterly profitability may create agency problems in that: A. the managers are not motivated by personal gain. B. the board of directors may claim the credit. C. short-term, not long-term profits become the focus. D. investors desire stable profits. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

90.

One continuing problem with managerial incentive compensation plans is that: A. the plans increase agency problems. B. managers prefer guaranteed salaries. C. their effectiveness is difficult to evaluate. D. the plans do not reward shareholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

91.

Which one of the following forms of compensation is most apt to align the interests of managers and shareholders? A. A fixed salary B. A salary that is linked to current company profits C. A salary that is paid partly in the form of the company's shares D. A salary that is linked to the company's market share AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems. Topic: Agency costs and problems

92.

Which of the following is a real asset? A. A patent B. A share of stock issued by Bank of New York C. An IOU ("I owe you") from your brother-in-law D. A mortgage loan taken out to help pay for a new home AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-02 Distinguish between real and financial assets. Topic: Financial management decisions

93.

Which one of these statements is correct? A. A dollar received next year has the same value as a dollar received today. B. Risky cash flows are more valuable than certain cash flows. C. Smart investment decisions create more value than smart financing decisions. D. Corporate governance is irrelevant. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make. Topic: Introduction to corporate finance

94.

Short selling involves selling a security: A. you do not own. B. that you have owned for less than one year. C. at a price below current market value. D. for less than you originally paid to purchase it. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 01-07 Explain why unethical behavior does not maximize market value. Topic: Introduction to corporate finance

Chapter 01 Test Bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Diversity

AACSB: Ethics

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 01-01 Give examples of the investment and financing decisions that financial managers make.

Learning Objective: 01-02 Distinguish between real and financial assets.

Learning Objective: 01-03 Cite some of the advantages and disadvantages of organizing a business as a corporation.

Learning Objective: 01-04 Describe the responsibilities of the CFO, treasurer; and controller.

Learning Objective: 01-05 Explain why maximizing market value is the natural financial goal of the corporation.

Learning Objective: 01-06 Understand what is meant by "agency problems" and cite some of the ways that corporate governance helps mitigate agency problems.

Learning Objective: 01-07 Explain why unethical behavior does not maximize market value.

Topic: Agency costs and problems

Topic: Capital structure

Topic: Ethics, governance, and regulation

Topic: Financial management decisions

Topic: Forms of business organization

Topic: Goal of financial management

Topic: Introduction to corporate finance

Topic: Management organization and roles

Chapter 02 Test Bank - Static Student: ___________________________________________________________________________

Only small companies can go through financial markets to obtain financing. True

The reinvestment of cash back into the firm's operations is an example of a flow of savings to investment. True

False

The markets for long-term debt and equity are called capital markets. True

False

Hedge fund managers, unlike mutual fund managers, do not receive fund-performance-related fees. True

False

Only the IPOs for large corporations are sold in primary markets. True

False

Previously issued securities are traded among investors in the secondary markets. True

False

An individual can save and invest in a corporation by lending money to it or by purchasing additional shares. True

False

Smaller businesses are especially dependent upon internally generated funds. True

False

The stocks of major corporations trade in many markets throughout the world on a continuous or near-continuous basis. True

False

10. The market for derivatives is also a source of financing for corporations. True

False

11. During the Financial Crisis of 2007-2009, the U.S. government bailed out all firms in danger of failing. True

False

12. In the United States, banks are the most important source of long-term financing for corporations. True

False

13. A financial intermediary invests in financial assets rather than real assets. True

False

14. Households hold directly three quarters of U.S. corporate equities. True

False

15. The key to the banks' ability to make illiquid loans is their ability to pool liquid deposits from thousands of depositors. True

False

16. From June 2001 to June 2006, house prices in the United States rose sharply. True

False

17. For corporate bonds, the higher the credit quality of an issuer, the higher the interest rate. True

False

18. The cost of capital is the interest rate paid on a loan from a bank or some other financial institution. True

False

19. Like public companies, private companies can also use their stock price as a measure of performance. True

False

20. The opportunity cost of capital is the expected rate of return that shareholders can obtain in the financial markets on investments with the same risk as the firm's capital investments. True

False

21. Once Apple Computer had become a public company, it was able to raise financing from venture capital companies True

False

22. Insurance companies provide a mechanism for individuals to pool their risks. True

False

23. Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. True

False

24. The effects of the financial crisis of 2007-2009 were confined to the U.S. and domestic companies. True

False

25. The cost of capital is the minimum acceptable rate of return for capital investment. True

False

26. One root of the financial crisis of 2007-2009 was the strict money policies promoted by the U.S. Federal Reserve and other central banks after the technology bubble burst (i.e., money was relatively expensive during this time). True

False

27. The rates of return on investments outside the corporation set the minimum return for investment projects inside the corporation. True

False

28. Financing for public corporations must flow through financial markets. True

False

29. Financing for private companies must flow through financial intermediaries such as mutual funds. True

False

30. Almost all foreign exchange trading occurs on the floors of the FOREX exchanges in New York and London. True

False

31. Corporate financing comes ultimately from: A. savings by households and foreign investors. B. cash generated from the firm's operations. C. the financial markets and intermediaries. D. the issue of shares in the firm. 32. A company can pay for its expansion in all the following ways except: A. by using the earnings generated from its sale of obsolete equipment. B. by persuading a director's mother to make a personal loan to the company. C. by purchasing bonds in the secondary market. D. by plowing back part of its profits. 33. "Reinvestment" means: A. new investment in new operations. B. additional investment in existing operations. C. new investment by new shareholders. D. the reinvestment of earnings into new projects. 34. Financing for public corporations flows through: A. the financial markets only. B. financial intermediaries only. C. derivatives markets. D. the financial markets, financial intermediaries, or both.

35. When corporations need to raise funds through stock issues, they rely on the: A. primary market. B. secondary market. C. tertiary market. D. centralized NASDAQ exchange. 36. A primary market would be utilized when: A. investors buy or sell existing securities. B. shares of common stock are exchanged. C. securities are initially issued. D. a commission must be paid on the transaction. 37. The primary distinction between securities sold in the primary and secondary markets is: A. the riskiness of the securities. B. the price of the securities. C. whether the securities are new or already exist. D. the profitability of the issuing corporation. 38. Which of the following are both a financial intermediary and a financial institution? A. Mutual funds B. Pension funds C. Insurance companies D. Hedge funds 39. A share of IBM stock is purchased by an individual investor for $75 and later sold to another investor for $125. Who profits from this sale? A. IBM B. The first investor C. The second investor D. IBM and both investors 40. Which of the following financial assets is least likely to have an active secondary market? A. Common stock of a large public firm B. Bank loans made to smaller firms C. Bonds of a major, multinational corporation D. Debt issued by the U.S. Treasury 41. When Patricia sells her General Motors common stock at the same time that Brian purchases the same amount of GM stock, GM receives: A. the dollar value of the transaction. B. the dollar amount of the transaction, less brokerage fees. C. only the par value of the common stock. D. nothing.

42. Which one of these is a money market security? A. Commercial paper B. Common stock C. 2-year bond D. 20-year bond 43. A mother in a developing country wants to borrow the equivalent of $20 to enable her to start a small restaurant run by her family. Which type of financing is she looking to obtain? A. Public bond issue B. IPO C. Micro loan D. Futures contract on a commodity 44. Corporate debt instruments are most commonly traded: A. on the NYSE. B. on NASDAQ. C. in the money market. D. in the over-the-counter market. 45. A bond differs from a share of stock in that a bond: A. represents a claim on the firm. B. has more risk. C. has guaranteed returns. D. has a maturity date. 46. Short-term financing transactions commonly occur in the: A. primary markets. B. secondary markets. C. capital markets. D. money markets. 47. Long-term financing decisions commonly occur in the: A. option markets. B. secondary markets. C. capital markets. D. money markets. 48. You can buy silver in the: A. capital markets. B. foreign exchange markets. C. commodities markets. D. option markets.

49. Commodity and derivative markets: A. are additional sources of financing for corporate projects. B. enable the financial manager to adjust a firm's exposure to various business risks. C. are always over-the-counter markets. D. deal only in foreign currencies. 50. Foreign currencies are traded: A. only by banks in New York and London. B. over the counter. C. on both the NYSE and NASDAQ. D. on the Intercontinental Exchange. 51. Which one of the following statements is not characteristic of mutual funds? A. They are always considered to be financial institutions. B. They raise money by selling shares to investors. C. They pool the savings of many investors. D. They offer professional management and portfolio diversification. 52. Which one of these correctly applies to mutual funds? A. Mutual funds are a costly means of achieving portfolio diversification. B. Funds are required to limit their annual fees and expenses to less than 1 percent of the portfolio value. C. You can generally buy additional shares in the fund at any time. D. Shareholders sell their shares to other shareholders. 53. "Balanced" mutual funds: A. invest in both stocks and bonds. B. spread their investments equally over a specified geographic area. C. spread their investments equally over various industries. D. charge a management fee that is proportionate to the investment return. 54. Who was responsible for the financial crisis of 2007-2009? A. The U.S. Federal Reserve, for its policy of easy money B. The U.S. government, for pushing banks to expand credit for low-income housing C. Bankers, who aggressively promoted and resold subprime mortgages D. The U.S. Federal Reserve, the U.S. government, rating agencies, and bankers 55. Which one of the following funds provides a tax advantage to individual investors? A. Balanced funds B. Pension funds C. Bond funds D. Funds that invest in foreign countries

56. A financial institution: A. is a kind of financial intermediary. B. simply pools and invests savings. C. raises financing by selling shares. D. invests primarily in commodities. 57. Which type of financial institution generally does not accept deposits but does underwrite stock offerings? A. Insurance company B. Mutual fund C. Commercial bank D. Investment bank 58. Which one of the following financial intermediaries has shown the greatest preference for investing in long-term financial assets? A. Commercial banks B. Insurance companies C. Finance companies D. Savings banks 59. Which one of these may provide a financial return to some investors while not providing any financial return to other investors? A. Mutual funds B. Pension funds C. Insurance companies D. Hedge fund 60. Insurance companies can usually cover the claims of policyholders because: A. the incidence of claims normally averages out across all policyholders. B. they issue a very limited number of policies. C. they are fully insured by the U.S. government. D. their stockholders will cover any cash shortfalls encountered by the company. 61. Which of the following is not typically considered a function of financial intermediaries? A. Providing a payment mechanism B. Investing in real assets C. Accumulating funds from smaller investors D. Spreading, or pooling risk among individuals 62. U.S. bonds and other debt securities are mostly held by: A. institutional investors. B. households. C. foreign investors. D. state and local governments.

63. Approximately what percentage of U.S. corporate equities are held by households? A. 20% B. 40% C. 60% D. 80% 64. Which of the following are major holders of corporate bonds? A. households. B. banks. C. insurance companies. D. New York Stock Exchange. 65. Which of the following is not a function of financial markets? A. allow individuals to diversify their risk. B. provide convenient ways to make large payments. C. allow individuals to purchase a range of goods online. D. provide funds to companies that wish to expand. 66. Which one of these transports income forward in time? A. Retirement savings B. Car loan C. Bank line of credit D. Credit card purchase 67. Which one of these assists in shifting an individual's consumption forward in time? A. A bank line of credit B. A bank savings account C. A life insurance policy D. A retirement savings plan 68. One reason suggesting that banks may be better than individuals at matching lenders to borrowers is that banks: A. can shift loan risk to their deposit customers. B. are motivated by the potential for profit. C. do not have any income tax liability. D. have information to evaluate creditworthiness. 69. Which one of the following is least liquid? A. Foreign currency B. U.S. Treasury bonds C. Real estate D. Bank deposit

70. Financial markets and intermediaries: A. channel savings to real investment. B. increase risks for businesses. C. generally reduce the liquidity of securities. D. prevent the transportation of cash across time. 71. Which of the following functions does not require financial markets? A. Retention of cash by corporations B. Provision of liquidity C. Risk reduction by investment in diversified portfolios D. Provision of pricing information 72. Liquidity is important to a mutual fund primarily because: A. a fund that is less liquid will attract more investors. B. the fund's shareholders may want to redeem their shares at any time. C. new investors may invest in the fund at any time. D. the fund requires cash to pay its taxes. 73. Which one of the following is the biggest provider of payment mechanisms? A. Hedge funds B. Banks C. Mutual funds D. Insurance companies 74. Which of the following actions does not help reduce risk? A. Extending the service warranty for your notebook B. Converting your money market account to a mutual fund account C. Contracting to sell your farm produce to the neighborhood grocery D. Buying Japanese yen now when you plan to study in Japan next year 75. Insurance companies primarily reduce an individual's risk by: A. transporting that risk forward in time. B. providing payment services. C. spreading that risk across many individuals. D. providing low-interest-rate loans. 76. Which of the following information is not provided by the financial markets? A. The price of six ounces of gold B. The cost of borrowing $500,000 for 5 years C. Microsoft's earnings in 2013 D. The cost of one million yen in U.S. dollars

77. A capital investment that generates a 10% rate of return is worthwhile if: A. corporate bonds of similar risk offer 8% rates of return. B. corporate bonds of similar risk offer 11% rates of return. C. top-quality corporate bonds offer 10% rates of return. D. the expected rate of return on the stock market is 12%. 78. The cost of capital: A. is the expected rate of return on a capital investment. B. is an opportunity cost determined by the risk-free rate of return. C. is the interest rate that the firm pays on a loan from a bank or insurance company. D. for risky investments is normally higher than the firm's borrowing rate. 79. Excess cash held by a firm should be: A. reinvested by the firm in projects offering the highest rate of return. B. reinvested by the firm in projects offering rates of return higher than the cost of capital. C. reinvested by the firm in the financial markets. D. distributed to bondholders in the form of extra coupon payments. 80. One contributing factor to the 2007-2009 financial crisis was the structuring of mortgage loans with: A. high initial payments, offset by significantly lower payments later. B. low initial payments, offset by significantly higher payments later. C. high initial payments, offset by high payments later. D. very short maturities. 81. The opportunity cost of capital: A. is the interest rate that the firm pays on a loan from a financial institution. B. is the maximum acceptable rate of return on a project. C. is the minimum acceptable rate of return on a project. D. is always less than 10%. 82. During the Financial Crisis of 2007-2009, the U.S. government bailed out all of the following firms except: A. AIG. B. Fannie Mae. C. Lehman Brothers. D. Freddie Mac. 83. If Apple Computer Inc. is used as the model, then new firms should expect to raise capital in which one of these orders? Start with the first money raised. A. Owners, venture capitalists, suppliers, public investors B. Owners, suppliers, venture capitalists, public investors C. Venture capitalists, owners, public investors, suppliers D. Owners, public investors, venture capitalists, suppliers

84. Which one of these parties cannot invest in a hedge fund? A. Small retail investors B. Pension funds C. Insurance companies D. Wealthy individuals 85. Which one of these enterprises generally acts as an underwriter for an initial public offering? A. Commercial bank B. Government C. Investment bank D. Insurance company 86. Which of these institutions are not major investors in U.S. equities? A. mutual funds B. banks C. pension funds D. hedge funds 87. Firms can often determine the price of any commodities they use in their production process by consulting the price quotes provided by: A. their investment bank. B. the New York Mercantile Exchange. C. the New York Stock Exchange. D. the Standard & Poor's market indexes. 88. How is the relationship between a bond's credit rating and its interest rate best defined? A. Inverse relationship B. Direct relationship C. Unrelated D. Logarithmic 89. The financial crisis of 2007-2009 contributed to the largest sovereign default in history by which one of these countries? A. Italy B. Portugal C. Ireland D. Greece 90. Which one of these was a contributing factor to the need for many foreign banks to seek aid from their governments as a result of the financial crisis of 2007-2009? A. Decrease in their exchange rates B. Investments in U.S. subprime mortgages C. Interest rate spikes D. Currency controls

91. Which one of these was a major cause of the deep recession and severe unemployment throughout much of Europe that followed the financial crisis of 2007-2009? A. Government actions to raise interest rates B. Investor speculation C. Risk-adverse investor attitudes D. Government actions to lower government debt 92. Which one of these is generally a key difference between U.S. and foreign commercial banks? A. Pooling and investing savings B. Accepting investor deposits C. Providing debt financing to corporations D. Making equity investments in corporations

Chapter 02 Test Bank - Static Key 1.

Only small companies can go through financial markets to obtain financing. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

The reinvestment of cash back into the firm's operations is an example of a flow of savings to investment. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Financial institution functions

Smaller businesses are especially dependent upon internally generated funds. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Financial institution functions

An individual can save and invest in a corporation by lending money to it or by purchasing additional shares. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Financial institution functions

Previously issued securities are traded among investors in the secondary markets. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy

Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Primary and secondary markets

Only the IPOs for large corporations are sold in primary markets. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Initial public offerings

Hedge fund managers, unlike mutual fund managers, do not receive fund-performance-related fees. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Types of financial institutions

The markets for long-term debt and equity are called capital markets. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Capital markets

The stocks of major corporations trade in many markets throughout the world on a continuous or near-continuous basis. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Stock trading

10.

The market for derivatives is also a source of financing for corporations. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Derivatives and other securities

11.

During the Financial Crisis of 2007-2009, the U.S. government bailed out all firms in danger of failing. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

12.

In the United States, banks are the most important source of long-term financing for corporations. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Financial institution functions

13.

A financial intermediary invests in financial assets rather than real assets. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Financial institutions

14.

Households hold directly three quarters of U.S. corporate equities. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Raising capital

15.

The key to the banks' ability to make illiquid loans is their ability to pool liquid deposits from thousands of depositors. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

16.

From June 2001 to June 2006, house prices in the United States rose sharply. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

17.

For corporate bonds, the higher the credit quality of an issuer, the higher the interest rate. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Bond ratings and credit risk

18.

The cost of capital is the interest rate paid on a loan from a bank or some other financial institution. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Cost of capital-general

19.

Like public companies, private companies can also use their stock price as a measure of performance. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Stock market prices and reporting

20.

The opportunity cost of capital is the expected rate of return that shareholders can obtain in the financial markets on investments with the same risk as the firm's capital investments. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Expected (required) return

21.

Once Apple Computer had become a public company, it was able to raise financing from venture capital companies FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Raising capital

22.

Insurance companies provide a mechanism for individuals to pool their risks. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

23.

Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

24.

The effects of the financial crisis of 2007-2009 were confined to the U.S. and domestic companies. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

25.

The cost of capital is the minimum acceptable rate of return for capital investment. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Expected (required) return

26.

One root of the financial crisis of 2007-2009 was the strict money policies promoted by the U.S. Federal Reserve and other central banks after the technology bubble burst (i.e., money was relatively expensive during this time). FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

27.

The rates of return on investments outside the corporation set the minimum return for investment projects inside the corporation. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Expected (required) return

28.

Financing for public corporations must flow through financial markets. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

29.

Financing for private companies must flow through financial intermediaries such as mutual funds. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

30.

Almost all foreign exchange trading occurs on the floors of the FOREX exchanges in New York and London. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Foreign exchange markets

31.

Corporate financing comes ultimately from: A. savings by households and foreign investors. B. cash generated from the firm's operations. C. the financial markets and intermediaries. D. the issue of shares in the firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Financial institution functions

32.

A company can pay for its expansion in all the following ways except: A. by using the earnings generated from its sale of obsolete equipment. B. by persuading a director's mother to make a personal loan to the company. C. by purchasing bonds in the secondary market. D. by plowing back part of its profits. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Raising capital

33.

"Reinvestment" means: A. new investment in new operations. B. additional investment in existing operations. C. new investment by new shareholders. D. the reinvestment of earnings into new projects. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Raising capital

34.

Financing for public corporations flows through: A. the financial markets only. B. financial intermediaries only. C. derivatives markets. D. the financial markets, financial intermediaries, or both. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

35.

When corporations need to raise funds through stock issues, they rely on the: A. primary market. B. secondary market. C. tertiary market. D. centralized NASDAQ exchange. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Primary and secondary markets

36.

A primary market would be utilized when: A. investors buy or sell existing securities. B. shares of common stock are exchanged. C. securities are initially issued. D. a commission must be paid on the transaction. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Primary and secondary markets

37.

The primary distinction between securities sold in the primary and secondary markets is: A. the riskiness of the securities. B. the price of the securities. C. whether the securities are new or already exist. D. the profitability of the issuing corporation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Primary and secondary markets

38.

Which of the following are both a financial intermediary and a financial institution? A. Mutual funds B. Pension funds C. Insurance companies D. Hedge funds AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions.

Topic: Financial institutions

39.

A share of IBM stock is purchased by an individual investor for $75 and later sold to another investor for $125. Who profits from this sale? A. IBM B. The first investor C. The second investor D. IBM and both investors AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Stock returns and yields

40.

Which of the following financial assets is least likely to have an active secondary market? A. Common stock of a large public firm B. Bank loans made to smaller firms C. Bonds of a major, multinational corporation D. Debt issued by the U.S. Treasury AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Primary and secondary markets

41.

When Patricia sells her General Motors common stock at the same time that Brian purchases the same amount of GM stock, GM receives: A. the dollar value of the transaction. B. the dollar amount of the transaction, less brokerage fees. C. only the par value of the common stock. D. nothing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Primary and secondary markets

42.

Which one of these is a money market security? A. Commercial paper B. Common stock C. 2-year bond D. 20-year bond AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Money and capital markets

43.

A mother in a developing country wants to borrow the equivalent of $20 to enable her to start a small restaurant run by her family. Which type of financing is she looking to obtain? A. Public bond issue B. IPO C. Micro loan D. Futures contract on a commodity AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Debt

44.

Corporate debt instruments are most commonly traded: A. on the NYSE. B. on NASDAQ. C. in the money market. D. in the over-the-counter market. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Primary and secondary markets

45.

A bond differs from a share of stock in that a bond: A. represents a claim on the firm. B. has more risk. C. has guaranteed returns. D. has a maturity date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Bond features

46.

Short-term financing transactions commonly occur in the: A. primary markets. B. secondary markets. C. capital markets. D. money markets. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Money and capital markets

47.

Long-term financing decisions commonly occur in the: A. option markets. B. secondary markets. C. capital markets. D. money markets. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Money and capital markets

48.

You can buy silver in the: A. capital markets. B. foreign exchange markets. C. commodities markets. D. option markets. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Money and capital markets

49.

Commodity and derivative markets: A. are additional sources of financing for corporate projects. B. enable the financial manager to adjust a firm's exposure to various business risks. C. are always over-the-counter markets. D. deal only in foreign currencies. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Derivatives and other securities

50.

Foreign currencies are traded: A. only by banks in New York and London. B. over the counter. C. on both the NYSE and NASDAQ. D. on the Intercontinental Exchange. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Foreign exchange markets

51.

Which one of the following statements is not characteristic of mutual funds? A. They are always considered to be financial institutions. B. They raise money by selling shares to investors. C. They pool the savings of many investors. D. They offer professional management and portfolio diversification. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Types of financial institutions

52.

Which one of these correctly applies to mutual funds? A. Mutual funds are a costly means of achieving portfolio diversification. B. Funds are required to limit their annual fees and expenses to less than 1 percent of the portfolio value. C. You can generally buy additional shares in the fund at any time. D. Shareholders sell their shares to other shareholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Types of financial institutions

53.

"Balanced" mutual funds: A. invest in both stocks and bonds. B. spread their investments equally over a specified geographic area. C. spread their investments equally over various industries. D. charge a management fee that is proportionate to the investment return. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds.

Topic: Types of financial institutions

54.

Who was responsible for the financial crisis of 2007-2009? A. The U.S. Federal Reserve, for its policy of easy money B. The U.S. government, for pushing banks to expand credit for low-income housing C. Bankers, who aggressively promoted and resold subprime mortgages D. The U.S. Federal Reserve, the U.S. government, rating agencies, and bankers AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

55.

Which one of the following funds provides a tax advantage to individual investors? A. Balanced funds B. Pension funds C. Bond funds D. Funds that invest in foreign countries AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Types of financial institutions

56.

A financial institution: A. is a kind of financial intermediary. B. simply pools and invests savings. C. raises financing by selling shares. D. invests primarily in commodities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institutions

57.

Which type of financial institution generally does not accept deposits but does underwrite stock offerings? A. Insurance company B. Mutual fund C. Commercial bank D. Investment bank AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Types of financial institutions

58.

Which one of the following financial intermediaries has shown the greatest preference for investing in long-term financial assets? A. Commercial banks B. Insurance companies C. Finance companies D. Savings banks AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Financial institution functions

59.

Which one of these may provide a financial return to some investors while not providing any financial return to other investors? A. Mutual funds B. Pension funds C. Insurance companies D. Hedge fund AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Types of financial institutions

60.

Insurance companies can usually cover the claims of policyholders because: A. the incidence of claims normally averages out across all policyholders. B. they issue a very limited number of policies. C. they are fully insured by the U.S. government. D. their stockholders will cover any cash shortfalls encountered by the company. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Types of financial institutions

61.

Which of the following is not typically considered a function of financial intermediaries? A. Providing a payment mechanism B. Investing in real assets C. Accumulating funds from smaller investors D. Spreading, or pooling risk among individuals AACSB: Communication

Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Financial institution functions

62.

U.S. bonds and other debt securities are mostly held by: A. institutional investors. B. households. C. foreign investors. D. state and local governments. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Raising capital

63.

Approximately what percentage of U.S. corporate equities are held by households? A. 20% B. 40% C. 60% D. 80% AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Raising capital

64.

Which of the following are major holders of corporate bonds? A. households. B. banks. C. insurance companies. D. New York Stock Exchange. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Raising capital

65.

Which of the following is not a function of financial markets? A. allow individuals to diversify their risk. B. provide convenient ways to make large payments. C. allow individuals to purchase a range of goods online. D. provide funds to companies that wish to expand. AACSB: Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

66.

Which one of these transports income forward in time? A. Retirement savings B. Car loan C. Bank line of credit D. Credit card purchase AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

67.

Which one of these assists in shifting an individual's consumption forward in time? A. A bank line of credit B. A bank savings account C. A life insurance policy D. A retirement savings plan AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

68.

One reason suggesting that banks may be better than individuals at matching lenders to borrowers is that banks: A. can shift loan risk to their deposit customers. B. are motivated by the potential for profit. C. do not have any income tax liability. D. have information to evaluate creditworthiness. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

69.

Which one of the following is least liquid? A. Foreign currency B. U.S. Treasury bonds C. Real estate D. Bank deposit AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

70.

Financial markets and intermediaries: A. channel savings to real investment. B. increase risks for businesses. C. generally reduce the liquidity of securities. D. prevent the transportation of cash across time. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

71.

Which of the following functions does not require financial markets? A. Retention of cash by corporations B. Provision of liquidity C. Risk reduction by investment in diversified portfolios D. Provision of pricing information AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

72.

Liquidity is important to a mutual fund primarily because: A. a fund that is less liquid will attract more investors. B. the fund's shareholders may want to redeem their shares at any time. C. new investors may invest in the fund at any time. D. the fund requires cash to pay its taxes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds.

Topic: Financial institution functions

73.

Which one of the following is the biggest provider of payment mechanisms? A. Hedge funds B. Banks C. Mutual funds D. Insurance companies AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

74.

Which of the following actions does not help reduce risk? A. Extending the service warranty for your notebook B. Converting your money market account to a mutual fund account C. Contracting to sell your farm produce to the neighborhood grocery D. Buying Japanese yen now when you plan to study in Japan next year AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

75.

Insurance companies primarily reduce an individual's risk by: A. transporting that risk forward in time. B. providing payment services. C. spreading that risk across many individuals. D. providing low-interest-rate loans. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Financial institution functions

76.

Which of the following information is not provided by the financial markets? A. The price of six ounces of gold B. The cost of borrowing $500,000 for 5 years C. Microsoft's earnings in 2013 D. The cost of one million yen in U.S. dollars AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic

Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

77.

A capital investment that generates a 10% rate of return is worthwhile if: A. corporate bonds of similar risk offer 8% rates of return. B. corporate bonds of similar risk offer 11% rates of return. C. top-quality corporate bonds offer 10% rates of return. D. the expected rate of return on the stock market is 12%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Expected (required) return

78.

The cost of capital: A. is the expected rate of return on a capital investment. B. is an opportunity cost determined by the risk-free rate of return. C. is the interest rate that the firm pays on a loan from a bank or insurance company. D. for risky investments is normally higher than the firm's borrowing rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Cost of capital-general

79.

Excess cash held by a firm should be: A. reinvested by the firm in projects offering the highest rate of return. B. reinvested by the firm in projects offering rates of return higher than the cost of capital. C. reinvested by the firm in the financial markets. D. distributed to bondholders in the form of extra coupon payments. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Goal of financial management

80.

One contributing factor to the 2007-2009 financial crisis was the structuring of mortgage loans with: A. high initial payments, offset by significantly lower payments later. B. low initial payments, offset by significantly higher payments later. C. high initial payments, offset by high payments later. D. very short maturities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

81.

The opportunity cost of capital: A. is the interest rate that the firm pays on a loan from a financial institution. B. is the maximum acceptable rate of return on a project. C. is the minimum acceptable rate of return on a project. D. is always less than 10%. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Expected (required) return

82.

During the Financial Crisis of 2007-2009, the U.S. government bailed out all of the following firms except: A. AIG. B. Fannie Mae. C. Lehman Brothers. D. Freddie Mac. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

83.

If Apple Computer Inc. is used as the model, then new firms should expect to raise capital in which one of these orders? Start with the first money raised. A. Owners, venture capitalists, suppliers, public investors B. Owners, suppliers, venture capitalists, public investors C. Venture capitalists, owners, public investors, suppliers D. Owners, public investors, venture capitalists, suppliers AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds. Topic: Raising capital

84.

Which one of these parties cannot invest in a hedge fund? A. Small retail investors B. Pension funds C. Insurance companies D. Wealthy individuals AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Hedging

85.

Which one of these enterprises generally acts as an underwriter for an initial public offering? A. Commercial bank B. Government C. Investment bank D. Insurance company AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Underwriting

86.

Which of these institutions are not major investors in U.S. equities? A. mutual funds B. banks C. pension funds D. hedge funds AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment. Topic: Raising capital

87.

Firms can often determine the price of any commodities they use in their production process by consulting the price quotes provided by: A. their investment bank. B. the New York Mercantile Exchange. C. the New York Stock Exchange. D. the Standard & Poor's market indexes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

88.

How is the relationship between a bond's credit rating and its interest rate best defined? A. Inverse relationship B. Direct relationship C. Unrelated D. Logarithmic AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Bond ratings and credit risk

89.

The financial crisis of 2007-2009 contributed to the largest sovereign default in history by which one of these countries? A. Italy B. Portugal C. Ireland D. Greece AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

90.

Which one of these was a contributing factor to the need for many foreign banks to seek aid from their governments as a result of the financial crisis of 2007-2009? A. Decrease in their exchange rates B. Investments in U.S. subprime mortgages C. Interest rate spikes D. Currency controls AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

91.

Which one of these was a major cause of the deep recession and severe unemployment throughout much of Europe that followed the financial crisis of 2007-2009? A. Government actions to raise interest rates B. Investor speculation C. Risk-adverse investor attitudes D. Government actions to lower government debt AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 02-04 Understand the main events behind the financial crisis of 2007-2009 and the subsequent eurozone crisis. Topic: Financial distress

92.

Which one of these is generally a key difference between U.S. and foreign commercial banks? A. Pooling and investing savings B. Accepting investor deposits C. Providing debt financing to corporations D. Making equity investments in corporations AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 02-03 Explain the functions of financial markets and institutions. Topic: Financial institution functions

Chapter 02 Test Bank - Static Summary Category

# of Questions

AACSB: Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 02-01 Understand how financial markets and institutions channel savings to corporate investment.

Learning Objective: 02-02 Understand the basic structure of banks, insurance companies, mutual funds, and pension funds.

Learning Objective: 02-03 Explain the functions of financial markets and institutions.

Learning Objective: 02-04 Understand the main events behind the financial crisis of 20072009 and the subsequent eurozone crisis.

Topic: Bond features

Topic: Bond ratings and credit risk

Topic: Capital markets

Topic: Cost of capital-general

Topic: Debt

Topic: Derivatives and other securities

Topic: Expected (required) return

Topic: Financial distress

Topic: Financial institution functions

Topic: Financial institutions

Topic: Foreign exchange markets

Topic: Goal of financial management

Topic: Hedging

Topic: Initial public offerings

Topic: Money and capital markets

Topic: Primary and secondary markets

Topic: Raising capital

Topic: Stock market prices and reporting

Topic: Stock returns and yields

Topic: Stock trading

Topic: Types of financial institutions

Topic: Underwriting

Chapter 03 Test Bank - Static Student: ___________________________________________________________________________

An asset's liquidity is determined by how readily the asset can be converted to an appropriate amount of cash. True

The principal reason for excluding many intangible assets from the balance sheet is that they are difficult to value. True

False

If the market value of assets is high, then the market value of liabilities must be high also. True

False

The income statement resembles a snapshot of the firm at a specific time. True

False

All items in the common-size balance sheet are expressed as a percentage of total assets. True

False

There is generally a bigger difference between the book value and the market value of fixed assets as compared to cash. True

False

Assets can be either tangible or intangible. True

False

Based on generally accepted accounting principles, assets are recorded on the balance sheet at their current market value. True

False

One reason for the difference between profits and cash is that the cost of capital equipment is spread over the forecast life. True

False

10. Accrual accounting aims to provide a fairer measure of the firm's profitability. True

False

11. If net income is positive, then cash flow from operations must be positive for that period. True

False

12. Dividends paid are treated as a financing activity on the statement of cash flows. True

False

13. An increase in the accounts receivable balance increases the cash flow of a firm. True

False

14. The payment of interest expense is considered a financing activity in the statement of cash flows. True

False

15. Accounting practices are currently standardized across all countries. True

False

16. Businesses that aggressively exploit any means possible to increase current earnings may cross over into fraudulent account practices. True

False

17. A company may deduct the interest paid to debtholders and the dividends paid to shareholders when calculating its taxable income. True

False

18. Both the dividends and interest payments that companies make to individuals are subject to personal tax. True

False

19. The balance sheet presents a snapshot of the firm's assets and liabilities at one particular moment. True

False

20. Book values are "forward-looking" measures of value. True

False

21. The difference between the market values of assets and liabilities is the market value of the shareholders' equity claim. True

False

22. To calculate free cash flow, you must deduct capital expenditures from the cash flow from operations. True

False

23. Depreciation charge is a cash payment. True

False

24. An expenditure on new capital equipment is a cash payment. True

False

25. The statement of cash flows shows the firm's cash inflows and outflows from operations as well as from its investments and financing activities. True

False

26. An increase in inventories uses cash, reducing the firm's net cash balance. True

False

27. A reduction in accounts receivable uses cash, reducing the firm's net cash balance. True

False

28. The purchase of new equipment is a use of cash, and it reduces the firm's net cash balance. True

False

29. In general, what is changing as you read down the left-hand side of a balance sheet? A. The assets are becoming more fully depreciated. B. The assets are increasing in value. C. The assets are increasing in maturity. D. The assets are becoming less liquid. 30. A balance sheet portrays the value of a firm's assets and liabilities: A. over an annual period. B. over any stated period of time. C. at any stated point in time. D. only at the end of the calendar year. 31. Which of the following items should not be included in a listing of current assets? A. Marketable securities B. Accounts payable C. Accounts receivable D. Inventories 32. Which of the following assets is likely to be considered the most liquid? A. Marketable securities B. Net fixed assets C. Accounts payable D. Inventories 33. If the value of a firm's net fixed assets equals the value of the accumulated depreciation, from an accounting context the fixed assets are: A. new. B. fully depreciated. C. one-half depreciated. D. equal in value to the firm's current assets.

34. If the balance sheet of a firm indicates that total assets exceed current liabilities plus shareholders' equity, then the firm has: A. no retained earnings. B. long-term debt. C. no accumulated depreciation. D. current assets. 35. Which one of the following is an intangible asset? A. Goodwill B. Retained earnings C. Deferred income taxes D. Treasury stock 36. Suppose Dee's just acquired the assets of Flo's Flowers. The book value of Flo's Flowers assets was $68,000 but Dee's paid a total of $75,000. The additional $7,000 paid by Dee's will be recorded on Dee's balance sheet as: A. accounts payable. B. goodwill. C. other current assets. D. property, plant, and equipment. 37. What happens to a firm's net worth as it uses cash to repay accounts payable? A. Net worth increases. B. Net worth decreases. C. Net worth remains constant. D. Net worth decreases temporarily, until cash is replenished. 38. If a payment of principal is due in 13 months on a long-term liability, that payment will now appear on the balance sheet as: A. a current liability. B. long-term debt. C. cash. D. interest expense. 39. Net working capital is a measure of a company's: A. goodwill. B. short-term liabilities. C. estimated cash reservoir. D. shareholders' equity. 40. Net working capital is calculated by taking the difference between: A. total assets and total liabilities. B. inventory and accounts payable. C. current assets and current liabilities. D. cash and accounts payable.

41. Which of the following statements about net working capital (NWC) is correct? A. NWC is positive for all firms. B. As NWC decreases, potential liquidity increases. C. NWC excludes inventory, which is deemed illiquid. D. NWC is negative if current liabilities exceed current assets. 42. The existence of goodwill on a corporate balance sheet indicates that the corporation has: A. been profitable in the past. B. depreciated its tangible assets. C. intangible assets from past acquisitions. D. retained earnings resulting from past income. 43. A balance sheet may be considered backward-looking from the perspective that it: A. works backward, starting with net income. B. records historic, not current values. C. cannot forecast the future. D. records costs over many previous periods. 44. According to GAAP, assets and liabilities are typically recorded on the balance sheet at: A. historical cost plus depreciation. B. market value. C. salvage value. D. historical cost less depreciation. 45. Which of the following statements about depreciation is correct A. Each year the accountant adds an amount for depreciation when calculating the company’s profit. B. The annual depreciation charge measures the cash that the company has spent on maintaining and renewing its plant and equipment. C. To calculate the cash produced by the business, it is necessary to deduct the depreciation charge from accounting profits. D. To calculate the cash produced by the business, it is necessary to add the depreciation charge back to accounting profits. 46. Depreciation expense is used to: A. allocate costs to all departments of the firm. B. determine when an asset is fully paid off. C. allocate historical cost over the life of an asset. D. equate the historical cost and market values of an asset. 47. When subtracting an asset's accumulated depreciation from its historic cost, the resulting value is termed the: A. book value of the asset. B. market value of the asset. C. depreciation expense. D. current asset value.

48. ABC Corp.'s balance sheet shows its long-term debt to be $20 million. The debt was issued with a 10% interest rate, and the current interest rate is 7%. Based on this information alone, the market value of this debt is most likely: A. less than $20 million. B. more than $20 million. C. equal to $20 million. D. unknown without knowing the maturity of the debt. 49. Which of the following statements about depreciation is correct? A. Depreciation is subtracted from cost of goods sold to calculate net income. B. When depreciation expense is incurred, cash balances are reduced. C. Depreciation expense does not affect net income. D. Depreciation reduces the book value of assets. 50. If market interest rates have increased since a company last borrowed long-term funds, the market value of these long-term funds will likely be: A. greater than their book value. B. less than their book value. C. equal to their book value. D. unknown without knowing the maturity of the debt. 51. Which of the following values would most likely interest a shareholder? A. Book value of equity B. Market value of equity C. Retained earnings D. Net working capital 52. What happens to the market value of a firm's equity as the book value of the firm's equity increases? A. It increases by the same amount. B. It decreases by the same amount. C. It remains constant. D. There is no set relationship to determine this outcome. 53. Which of the following statements is true for a corporation with $1 million market value of equity, $2 million market value of assets, and 1,000 shares of outstanding stock? A. Market value of liabilities exceeds book value of liabilities. B. Market value of liabilities equals $1 million. C. Book value per share equals $1,000. D. Market value per share equals $2,000. 54. Which of the following is more likely to be correct if market value of equity is less than book value of equity? A. Investors anticipate excellent earning potential. B. Investors anticipate low earning potential. C. Assets have been fully depreciated. D. The company is bankrupt.

55. Market-value balance sheets differ from book-value balance sheets in that market values: A. are higher than book values. B. are lower than book values. C. reflect GAAP accounting. D. reflect investors' expectations. 56. If market values of equity exceed book values of equity, then: A. equity has been depreciated too rapidly. B. the firm uses accrual-based accounting. C. profit potential is expected to be attractive. D. the firm is holding too much cash. 57. Perhaps the best method for estimating the market value of shareholders' equity is to: A. review the firm's balance sheet. B. review the firm's income statement. C. multiply number of shares outstanding by the price of each share. D. add the retained earnings to the total liabilities. 58. In which of the following balance-sheet entries are you least likely to find a difference between market value and book value? A. Cash B. Inventory C. Land D. Shareholders' equity 59. Amy wants to know if inventory is increasing as a percentage of total assets. Which one of these statements most easily provides the information she is seeking? A. Statement of cash flows B. Balance sheet C. Common-size balance sheet D. Income statement 60. Which one of the following expense categories is subtracted from total revenues to help arrive at a firm's EBIT? A. Cash dividends B. Depreciation expense C. Interest expense D. Tax liability 61. Which one of the following does not reduce a firm's net income? A. Income taxes B. Interest expense C. Dividends D. Depreciation expense

62. Calculate the EBIT for a firm with $4 million total revenues, $3.5 million cost of goods sold, $500,000 depreciation expense, and $120,000 interest expense. A. $500,000 B. $380,000 C. $0 D. ($120,000) 63. The net income figure on an income statement is calculated before deducting the: A. interest expense. B. depreciation expense. C. cash dividends. D. tax liability. 64. An increase in depreciation expense will (other things equal): A. increase net income. B. decrease net income. C. increase taxable income. D. decrease the market value of assets. 65. Current period depreciation expense is listed: A. on the balance sheet. B. in the investment section of the cash flow statement. C. on the income statement. D. on neither the balance sheet nor the income statement; it is a noncash expense. 66. Retained earnings result from: A. the sale of additional shares of stock to investors. B. income not paid to shareholders. C. an excess of assets over liabilities. D. market values that exceed book values. 67. The gathering of related revenues and expenses into the same period, regardless of when they were incurred, is: A. cash-basis accounting. B. market-value accounting. C. book-value accounting. D. accrual accounting. 68. According to accrual accounting, when goods are not sold until the period after they were produced, then the cost of goods sold will be: A. recognized when the goods are produced. B. recognized when the goods are sold. C. recognized when payment is received. D. split between the production and the sale periods.

69. Accrual accounting, which attempts to match sales revenues and the expenses associated with the production of the goods, is conducted in an attempt to: A. reduce income-tax liability. B. reduce bias in reported profitability measures. C. speed up the receipt of accounts receivable. D. reduce the time necessary to depreciate assets. 70. Which of the firm's financial statements most clearly recognizes the payment for new equipment? A. Balance sheet B. Income statement C. Statement of cash flows D. Common-size balance sheet 71. If a firm pays taxes, which one of these will reduce net income but increase cash flow? A. Depreciation expense B. Income taxes C. Cash sales D. Interest expense 72. Which one of the following will reduce the cash flow during an accounting period? A. High depreciation expense B. Reduction of inventory levels C. Acquisition of equipment D. Increase in accounts payable 73. Assume a firm generates $2,000 in sales and has a $500 increase in accounts receivable during an accounting period. Based solely on this information, cash flow will increase by: A. $2,500. B. $2,000. C. $1,500. D. $500. 74. In a statement of cash flows, which category includes depreciation expense as a line item? A. Cash provided by operations. B. Cash flows from investments. C. Cash provided by (used for) financing activities. D. Current liabilities. 75. Which of the following will occur in a statement of cash flows as a result of paying cash dividends? A. Cash flows from operations will increase. B. Cash flows from investments will decrease. C. Cash flows from financing will decrease. D. Cash balances will not be affected.

76. Which of the following changes in working capital will result in an increase in cash flows? A. Increase in accounts payable B. Increase in inventories C. Increase in accounts receivable D. Decrease in other current liabilities 77. Which of the following statements is more likely if cash and marketable securities increase by $5,000 during a period in which cash provided by operations increases by $1,000 and cash used by investments decreases by $500? A. Cash provided by financing increases by $6,500. B. Cash used by financing decreases by $1,000. C. Debt increases by more than cash dividends paid. D. Debt is reduced by more than cash dividends paid. 78. If a firm's net income is positive and its noncash expenses are positive, which of the following could account for a negative amount of cash provided by operations? A. Current assets decrease more than current liabilities decrease. B. Current assets increase more than current liabilities increase. C. Current assets decrease more than current liabilities increase. D. A large addition is made to plant and equipment. 79. What is the most likely conclusion for a firm whose statement of cash flows shows an increase in cash balances and has negative cash flows from both operations and financing? A. The firm has low depreciation expense. B. The firm did not pay any dividends. C. The firm sold more equipment than it purchased. D. The firm has a low interest rate on its debt. 80. Johnson's Nursery has net income of $42,500, depreciation expense of $1,800, interest expense of $900, taxes of $1,600, additions to net working capital of $2,300, and capital expenditures of $11,700. What is the amount of the free cash flow? A. $30,300 B. $34,400 C. $31,200 D. $28,700 81. According to the statement of cash flows, cash flows from financing could be positive if: A. the firm repaid more debt than it added. B. the firm added more debt than it repaid. C. interest rates were low on outstanding debt. D. the firm sold portions of its plant and equipment. 82. Which of the following categories of a statement of cash flows is affected by the payment of interest expense? A. Cash flows from operations B. Cash flows from noncash expenses C. Cash flows from investments D. Cash flows from financing

83. Which of the following could account for a firm that has a negative net income, yet has a positive amount of cash provided by operations? A. The net loss was greater than the amount of depreciation expense. B. Inventory increased significantly more than accounts payable. C. Accounts receivable decreased by significantly more than accounts payable. D. The cash balance increased significantly. 84. If a firm's statement of cash flows shows that cash was used for investments, which of the following would seem most likely? A. The inventory balance increased. B. Common stock was repurchased. C. New machines were acquired. D. Cash dividends were paid. 85. Interest expense appears in the operations section of the statement of cash flows because: A. firms cannot operate without incurring interest expense. B. its payment is not within managerial discretion. C. it is paid to finance a firm's inventory. D. none of the options; interest expense appears in the financing section of the statement of cash flows. 86. Which one of these would not be paid from free cash flow? A. Cash dividends B. Repayment of principal on a long-term debt C. Repurchase of outstanding shares of common stock D. New equipment purchase 87. Which of the following statements correctly describes international accounting standards? A. The standards are becoming less similar over time. B. They are concerned only with assets and not liabilities. C. Compared with standards in the United States international standards involve less detailed rules . D. Balance sheets differ, but income statements are similar in all countries. 88. Which of these statements related to free cash flow is correct? A. Free cash flow must be fully distributed to the firm's debtors and shareholders. B. Free cash flow must be positive for a firm to acquire new fixed assets. C. All, or part, of free cash flow can be used to increase a firm's cash reserves. D. When capital expenditures are positive, free cash flow will exceed the cash flow from operations. 89. What is the fundamental difference between IFRS and GAAP? A. GAAP relies more on general principles but ignores the spirit of those principles. B. GAAP relies more on specific rules and the spirit of the rules. C. GAAP relies more on specific rules but not the spirit of the rules. D. GAAP relies more on general principles as well as the spirit of those rules.

90. A company pays tax at a rate of 15% on its first $50,000 of income. If it has $60,000 of taxable income and an average tax rate of 18%, what is the marginal tax rate on its last $10,000 of income? A. 15% B. 33% C. 18% D. 25% 91. Assume a company pays tax at a rate of 15% on its first $50,000 of income. Any income above $50,000 is taxed at 25%. If a company has $75,000 of taxable income, which of the following statements is correct? A. Its marginal tax rate is 15%. B. Its average tax rate is 25%. C. Its marginal tax rate is 18.33%. D. Its average tax rate is 18.33%. 92. What is the marginal corporate tax rate for large companies? A. 15% B. 34% C. 35% D. 39% 93. Which of the following cannot be used to reduce taxable corporate income? A. Cash dividends B. Depreciation expense C. Interest expense D. Administrative expenses 94. Assume a firm increases its revenue by $100 while increasing its cost of goods sold by $85. How much additional tax will the firm owe if its marginal tax rate is 25%? A. $3.75 B. $7.50 C. $13.75 D. $25.00 95. According to the U.S. tax code at the beginning of 2016, the highest marginal tax rate for personal taxpayers is: A. 25.0%. B. 28.5%. C. 35.0%. D. 39.6%. 96. Which one of the following statements is correct for a corporation with a negative net income in both the present and the last fiscal year? A. This year's loss can be carried back, but last year's loss cannot be used. B. Neither of the losses can be used to reduce taxes. C. Both losses can be carried forward but not backward. D. Both losses can be carried forward and backward, within certain time limits.

97. Assume a single taxpayer is taxed at 10% on the first $9,275 of taxable income, 15% on the next $28,375 of income, and at 25% for the following $53,500 of income. What is the average tax rate for that individual if her taxable income is $42,000? A. 14.93% B. 16.67% C. 16.13% D. 25% 98. An individual's income for the year includes both dividend and interest payments. Which of these statements correctly applies to that individual's tax liability? A. Dividends are taxed; tax on interest payments is paid at the corporate level. B. Interest is taxed; tax on dividend payments is paid at the corporate level. C. Both dividend and interest payments are taxed at the personal level. D. All taxes on dividend and interest payments are paid at the corporate level. 99. A major goal of the Sarbanes-Oxley Act is to: A. increase transparency in the financial reporting of a firm's activities. B. require firms to provide common-size balance sheets to shareholders. C. lower corporate tax rates. D. require U.S. firms to abide by international accounting standards. 100. Which one of the following is not a requirement imposed by the Sarbanes-Oxley Act? A. Accounting firms may not offer other services to companies they audit. B. Any one individual is prohibited from serving as the chairman of a firm's board of directors for more than 5 years. C. A board's audit committee must consist of directors who are independent of the firm's management. D. Management must certify that the financial statements present a fair view of the firm's financial position. 101. Who pays taxes on earnings distributed as dividends? A. The issuing corporation B. The shareholder receiving the dividend C. Both the issuing corporation and the shareholder D. Neither the issuing corporation nor the shareholder 102. Assume tax rates on single individuals are 10% on taxable income up to $9,275, 15% on income of $9,276 to $37,650 and 25% on income of $37,651 to $91,150. What is the tax liability for a single individual with $52,000 of taxable income, which includes $2,000 of dividends? A. $8,771.25 B. $9,103.50 C. $8,603.50 D. $8,356.25 103. Which of the following forms of income can individuals defer from taxation? A. Dividends B. Interest C. Realized capital gains D. Unrealized capital gains

104. Which type of income is subject to "double taxation"? A. Dividends and wages B. Capital gains C. Dividends D. Wages 105. Professor Diehard found an effective antibiotic for the DEPRESS bacteria, and patented the drug. He believes that he could sell the patent for $20 million. He then formed a corporation and invested $400,000 in setting up a production plant. There are 2 million shares of stock outstanding. If the professor's belief is correct, what would be the price per share and the book value per share? A. $10.20; $0.20 B. $10.00; $0.20 C. $9.80; $0.40 D. $9.80; $0.20 106. You have gathered this information on a firm: $500,000 sales, $10,000 cash dividends, $300,000 cost of goods sold, $20,000 administrative expense, $20,000 depreciation expense, $40,000 interest expense, $10,000 purchase of productive equipment, no changes in working capital, and a tax rate of 35%. What is the free cash flow? A. $141,000 B. $168,000 C. $128,000 D. $142,000 107. What is the overall change in cash resulting from: $300 increase in inventories, $150 increase in accounts payable, $120 decrease in accounts receivable, $60 decrease in other current assets, $150 decrease in other current liabilities? A. −$120 B. −$240 C. $180 D. $120 108. What is the change in cash for a firm with the following: $10,000 cash flow from operations, $1,600 cash used for new investment, a reduction in the level of debt of $2,000, $1,000 in cash dividends, and $200 in depreciation expense? A. $5,600 B. $9,600 C. $9,400 D. $5,400 109. What are the average and marginal tax rates for a corporation that has $97,648 of taxable income? The tax rates are as follows: A. 21.97%; 25% B. 21.97%; 34% C. 23.08%; 34% D. 34%; 34%

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

Chapter 03 Test Bank - Static Key 1.

An asset's liquidity is determined by how readily the asset can be converted to an appropriate amount of cash. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Liquidity

The principal reason for excluding many intangible assets from the balance sheet is that they are difficult to value. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

Based on generally accepted accounting principles, assets are recorded on the balance sheet at their current market value. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Market and book values

Assets can be either tangible or intangible. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

There is generally a bigger difference between the book value and the market value of fixed assets as compared to cash. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy

Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Market and book values

All items in the common-size balance sheet are expressed as a percentage of total assets. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Standardized financial statements

The income statement resembles a snapshot of the firm at a specific time. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Income statement

If the market value of assets is high, then the market value of liabilities must be high also. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Market and book values

One reason for the difference between profits and cash is that the cost of capital equipment is spread over the forecast life. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Noncash items

10.

Accrual accounting aims to provide a fairer measure of the firm's profitability. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

11.

If net income is positive, then cash flow from operations must be positive for that period. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Operating activities

12.

Dividends paid are treated as a financing activity on the statement of cash flows. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

13.

An increase in the accounts receivable balance increases the cash flow of a firm. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Operating activities

14.

The payment of interest expense is considered a financing activity in the statement of cash flows. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

15.

Accounting practices are currently standardized across all countries. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

16.

Businesses that aggressively exploit any means possible to increase current earnings may cross over into fraudulent account practices. TRUE AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Ethics, governance, and regulation

17.

A company may deduct the interest paid to debtholders and the dividends paid to shareholders when calculating its taxable income. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Income statement

18.

Both the dividends and interest payments that companies make to individuals are subject to personal tax. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

19.

The balance sheet presents a snapshot of the firm's assets and liabilities at one particular moment. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

20.

Book values are "forward-looking" measures of value. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

21.

The difference between the market values of assets and liabilities is the market value of the shareholders' equity claim. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Market and book values

22.

To calculate free cash flow, you must deduct capital expenditures from the cash flow from operations. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Free cash flow

23.

Depreciation charge is a cash payment. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Noncash items

24.

An expenditure on new capital equipment is a cash payment. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Investing activities

25.

The statement of cash flows shows the firm's cash inflows and outflows from operations as well as from its investments and financing activities. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

26.

An increase in inventories uses cash, reducing the firm's net cash balance. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Sources and uses of cash

27.

A reduction in accounts receivable uses cash, reducing the firm's net cash balance. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Sources and uses of cash

28.

The purchase of new equipment is a use of cash, and it reduces the firm's net cash balance. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Sources and uses of cash

29.

In general, what is changing as you read down the left-hand side of a balance sheet? A. The assets are becoming more fully depreciated. B. The assets are increasing in value. C. The assets are increasing in maturity. D. The assets are becoming less liquid. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Liquidity

30.

A balance sheet portrays the value of a firm's assets and liabilities: A. over an annual period. B. over any stated period of time. C. at any stated point in time. D. only at the end of the calendar year. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

31.

Which of the following items should not be included in a listing of current assets? A. Marketable securities B. Accounts payable C. Accounts receivable D. Inventories AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

32.

Which of the following assets is likely to be considered the most liquid? A. Marketable securities B. Net fixed assets C. Accounts payable D. Inventories AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Liquidity

33.

If the value of a firm's net fixed assets equals the value of the accumulated depreciation, from an accounting context the fixed assets are: A. new. B. fully depreciated. C. one-half depreciated. D. equal in value to the firm's current assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

34.

If the balance sheet of a firm indicates that total assets exceed current liabilities plus shareholders' equity, then the firm has: A. no retained earnings. B. long-term debt. C. no accumulated depreciation. D. current assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

35.

Which one of the following is an intangible asset? A. Goodwill B. Retained earnings C. Deferred income taxes D. Treasury stock AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

36.

Suppose Dee's just acquired the assets of Flo's Flowers. The book value of Flo's Flowers assets was $68,000 but Dee's paid a total of $75,000. The additional $7,000 paid by Dee's will be recorded on Dee's balance sheet as: A. accounts payable. B. goodwill. C. other current assets. D. property, plant, and equipment. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

37.

What happens to a firm's net worth as it uses cash to repay accounts payable? A. Net worth increases. B. Net worth decreases. C. Net worth remains constant. D. Net worth decreases temporarily, until cash is replenished. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows.

Topic: Balance sheet

38.

If a payment of principal is due in 13 months on a long-term liability, that payment will now appear on the balance sheet as: A. a current liability. B. long-term debt. C. cash. D. interest expense. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

39.

Net working capital is a measure of a company's: A. goodwill. B. short-term liabilities. C. estimated cash reservoir. D. shareholders' equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Net working capital

40.

Net working capital is calculated by taking the difference between: A. total assets and total liabilities. B. inventory and accounts payable. C. current assets and current liabilities. D. cash and accounts payable. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Net working capital

41.

Which of the following statements about net working capital (NWC) is correct? A. NWC is positive for all firms. B. As NWC decreases, potential liquidity increases. C. NWC excludes inventory, which is deemed illiquid. D. NWC is negative if current liabilities exceed current assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic

Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Net working capital

42.

The existence of goodwill on a corporate balance sheet indicates that the corporation has: A. been profitable in the past. B. depreciated its tangible assets. C. intangible assets from past acquisitions. D. retained earnings resulting from past income. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

43.

A balance sheet may be considered backward-looking from the perspective that it: A. works backward, starting with net income. B. records historic, not current values. C. cannot forecast the future. D. records costs over many previous periods. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

44.

According to GAAP, assets and liabilities are typically recorded on the balance sheet at: A. historical cost plus depreciation. B. market value. C. salvage value. D. historical cost less depreciation. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

45.

Which of the following statements about depreciation is correct A. Each year the accountant adds an amount for depreciation when calculating the company’s profit. B. The annual depreciation charge measures the cash that the company has spent on maintaining and renewing its plant and equipment. C. To calculate the cash produced by the business, it is necessary to deduct the depreciation charge from accounting profits. D. To calculate the cash produced by the business, it is necessary to add the depreciation charge back to accounting profits. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Depreciation

46.

Depreciation expense is used to: A. allocate costs to all departments of the firm. B. determine when an asset is fully paid off. C. allocate historical cost over the life of an asset. D. equate the historical cost and market values of an asset. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Noncash items

47.

When subtracting an asset's accumulated depreciation from its historic cost, the resulting value is termed the: A. book value of the asset. B. market value of the asset. C. depreciation expense. D. current asset value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Market and book values

48.

ABC Corp.'s balance sheet shows its long-term debt to be $20 million. The debt was issued with a 10% interest rate, and the current interest rate is 7%. Based on this information alone, the market value of this debt is most likely: A. less than $20 million. B. more than $20 million. C. equal to $20 million. D. unknown without knowing the maturity of the debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Market and book values

49.

Which of the following statements about depreciation is correct? A. Depreciation is subtracted from cost of goods sold to calculate net income. B. When depreciation expense is incurred, cash balances are reduced. C. Depreciation expense does not affect net income. D. Depreciation reduces the book value of assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Noncash items

50.

If market interest rates have increased since a company last borrowed long-term funds, the market value of these long-term funds will likely be: A. greater than their book value. B. less than their book value. C. equal to their book value. D. unknown without knowing the maturity of the debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

51.

Which of the following values would most likely interest a shareholder? A. Book value of equity B. Market value of equity C. Retained earnings D. Net working capital AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

52.

What happens to the market value of a firm's equity as the book value of the firm's equity increases? A. It increases by the same amount. B. It decreases by the same amount. C. It remains constant. D. There is no set relationship to determine this outcome. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values.

Topic: Market and book values

53.

Which of the following statements is true for a corporation with $1 million market value of equity, $2 million market value of assets, and 1,000 shares of outstanding stock? A. Market value of liabilities exceeds book value of liabilities. B. Market value of liabilities equals $1 million. C. Book value per share equals $1,000. D. Market value per share equals $2,000. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Market and book values

54.

Which of the following is more likely to be correct if market value of equity is less than book value of equity? A. Investors anticipate excellent earning potential. B. Investors anticipate low earning potential. C. Assets have been fully depreciated. D. The company is bankrupt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

55.

Market-value balance sheets differ from book-value balance sheets in that market values: A. are higher than book values. B. are lower than book values. C. reflect GAAP accounting. D. reflect investors' expectations. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

56.

If market values of equity exceed book values of equity, then: A. equity has been depreciated too rapidly. B. the firm uses accrual-based accounting. C. profit potential is expected to be attractive. D. the firm is holding too much cash. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

57.

Perhaps the best method for estimating the market value of shareholders' equity is to: A. review the firm's balance sheet. B. review the firm's income statement. C. multiply number of shares outstanding by the price of each share. D. add the retained earnings to the total liabilities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

58.

In which of the following balance-sheet entries are you least likely to find a difference between market value and book value? A. Cash B. Inventory C. Land D. Shareholders' equity AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

59.

Amy wants to know if inventory is increasing as a percentage of total assets. Which one of these statements most easily provides the information she is seeking? A. Statement of cash flows B. Balance sheet C. Common-size balance sheet D. Income statement AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Standardized financial statements

60.

Which one of the following expense categories is subtracted from total revenues to help arrive at a firm's EBIT? A. Cash dividends B. Depreciation expense C. Interest expense D. Tax liability AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Income statement

61.

Which one of the following does not reduce a firm's net income? A. Income taxes B. Interest expense C. Dividends D. Depreciation expense AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Income statement

62.

Calculate the EBIT for a firm with $4 million total revenues, $3.5 million cost of goods sold, $500,000 depreciation expense, and $120,000 interest expense. A. $500,000 B. $380,000 C. $0 D. ($120,000) EBIT = $4,000,000 − 3,500,000 − 500,000 = $0

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Income statement

63.

The net income figure on an income statement is calculated before deducting the: A. interest expense. B. depreciation expense. C. cash dividends. D. tax liability. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Income statement

64.

An increase in depreciation expense will (other things equal): A. increase net income. B. decrease net income. C. increase taxable income. D. decrease the market value of assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Income statement

65.

Current period depreciation expense is listed: A. on the balance sheet. B. in the investment section of the cash flow statement. C. on the income statement. D. on neither the balance sheet nor the income statement; it is a noncash expense. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Noncash items

66.

Retained earnings result from: A. the sale of additional shares of stock to investors. B. income not paid to shareholders. C. an excess of assets over liabilities. D. market values that exceed book values. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Balance sheet

67.

The gathering of related revenues and expenses into the same period, regardless of when they were incurred, is: A. cash-basis accounting. B. market-value accounting. C. book-value accounting. D. accrual accounting. AACSB: Communication

Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

68.

According to accrual accounting, when goods are not sold until the period after they were produced, then the cost of goods sold will be: A. recognized when the goods are produced. B. recognized when the goods are sold. C. recognized when payment is received. D. split between the production and the sale periods. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

69.

Accrual accounting, which attempts to match sales revenues and the expenses associated with the production of the goods, is conducted in an attempt to: A. reduce income-tax liability. B. reduce bias in reported profitability measures. C. speed up the receipt of accounts receivable. D. reduce the time necessary to depreciate assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

70.

Which of the firm's financial statements most clearly recognizes the payment for new equipment? A. Balance sheet B. Income statement C. Statement of cash flows D. Common-size balance sheet AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

71.

If a firm pays taxes, which one of these will reduce net income but increase cash flow? A. Depreciation expense B. Income taxes C. Cash sales D. Interest expense AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Noncash items

72.

Which one of the following will reduce the cash flow during an accounting period? A. High depreciation expense B. Reduction of inventory levels C. Acquisition of equipment D. Increase in accounts payable AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Statement of cash flows

73.

Assume a firm generates $2,000 in sales and has a $500 increase in accounts receivable during an accounting period. Based solely on this information, cash flow will increase by: A. $2,500. B. $2,000. C. $1,500. D. $500. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Operating activities

74.

In a statement of cash flows, which category includes depreciation expense as a line item? A. Cash provided by operations. B. Cash flows from investments. C. Cash provided by (used for) financing activities. D. Current liabilities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic

Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

75.

Which of the following will occur in a statement of cash flows as a result of paying cash dividends? A. Cash flows from operations will increase. B. Cash flows from investments will decrease. C. Cash flows from financing will decrease. D. Cash balances will not be affected. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

76.

Which of the following changes in working capital will result in an increase in cash flows? A. Increase in accounts payable B. Increase in inventories C. Increase in accounts receivable D. Decrease in other current liabilities AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

77.

Which of the following statements is more likely if cash and marketable securities increase by $5,000 during a period in which cash provided by operations increases by $1,000 and cash used by investments decreases by $500? A. Cash provided by financing increases by $6,500. B. Cash used by financing decreases by $1,000. C. Debt increases by more than cash dividends paid. D. Debt is reduced by more than cash dividends paid. Cash provided by financing increased. This could occur by increasing debt by a larger amount than the amount paid out in dividends.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Statement of cash flows

78.

If a firm's net income is positive and its noncash expenses are positive, which of the following could account for a negative amount of cash provided by operations? A. Current assets decrease more than current liabilities decrease. B. Current assets increase more than current liabilities increase. C. Current assets decrease more than current liabilities increase. D. A large addition is made to plant and equipment. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Operating activities

79.

What is the most likely conclusion for a firm whose statement of cash flows shows an increase in cash balances and has negative cash flows from both operations and financing? A. The firm has low depreciation expense. B. The firm did not pay any dividends. C. The firm sold more equipment than it purchased. D. The firm has a low interest rate on its debt. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Statement of cash flows

80.

Johnson's Nursery has net income of $42,500, depreciation expense of $1,800, interest expense of $900, taxes of $1,600, additions to net working capital of $2,300, and capital expenditures of $11,700. What is the amount of the free cash flow? A. $30,300 B. $34,400 C. $31,200 D. $28,700 Free cash flow = $42,500 + 900 + 1,800 − 2,300 − 11,700 = $31,200

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Free cash flow

81.

According to the statement of cash flows, cash flows from financing could be positive if: A. the firm repaid more debt than it added. B. the firm added more debt than it repaid. C. interest rates were low on outstanding debt. D. the firm sold portions of its plant and equipment. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Financing activities

82.

Which of the following categories of a statement of cash flows is affected by the payment of interest expense? A. Cash flows from operations B. Cash flows from noncash expenses C. Cash flows from investments D. Cash flows from financing AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Operating activities

83.

Which of the following could account for a firm that has a negative net income, yet has a positive amount of cash provided by operations? A. The net loss was greater than the amount of depreciation expense. B. Inventory increased significantly more than accounts payable. C. Accounts receivable decreased by significantly more than accounts payable. D. The cash balance increased significantly. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Operating activities

84.

If a firm's statement of cash flows shows that cash was used for investments, which of the following would seem most likely? A. The inventory balance increased. B. Common stock was repurchased. C. New machines were acquired. D. Cash dividends were paid. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Investing activities

85.

Interest expense appears in the operations section of the statement of cash flows because: A. firms cannot operate without incurring interest expense. B. its payment is not within managerial discretion. C. it is paid to finance a firm's inventory. D. none of the options; interest expense appears in the financing section of the statement of cash flows. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Operating activities

86.

Which one of these would not be paid from free cash flow? A. Cash dividends B. Repayment of principal on a long-term debt C. Repurchase of outstanding shares of common stock D. New equipment purchase AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Free cash flow

87.

Which of the following statements correctly describes international accounting standards? A. The standards are becoming less similar over time. B. They are concerned only with assets and not liabilities. C. Compared with standards in the United States international standards involve less detailed rules . D. Balance sheets differ, but income statements are similar in all countries. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

88.

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

Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Free cash flow

89.

What is the fundamental difference between IFRS and GAAP? A. GAAP relies more on general principles but ignores the spirit of those principles. B. GAAP relies more on specific rules and the spirit of the rules. C. GAAP relies more on specific rules but not the spirit of the rules. D. GAAP relies more on general principles as well as the spirit of those rules. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Generally Accepted Accounting Principles (GAAP)

90.

A company pays tax at a rate of 15% on its first $50,000 of income. If it has $60,000 of taxable income and an average tax rate of 18%, what is the marginal tax rate on its last $10,000 of income? A. 15% B. 33% C. 18% D. 25% 0.18 × $60,000 = (0.15 × $50,000) + (x × ($60,000 − 50,000)) $10,800 = $7,500 + $10,000x x = 0.33, or 33%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

91.

Assume a company pays tax at a rate of 15% on its first $50,000 of income. Any income above $50,000 is taxed at 25%. If a company has $75,000 of taxable income, which of the following statements is correct? A. Its marginal tax rate is 15%. B. Its average tax rate is 25%. C. Its marginal tax rate is 18.33%. D. Its average tax rate is 18.33%. (0.15 × $50,000 + 0.25 × $25,000)/$75,000 = 0.1833

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

92.

What is the marginal corporate tax rate for large companies? A. 15% B. 34% C. 35% D. 39% AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

93.

Which of the following cannot be used to reduce taxable corporate income? A. Cash dividends B. Depreciation expense C. Interest expense D. Administrative expenses AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

94.

Assume a firm increases its revenue by $100 while increasing its cost of goods sold by $85. How much additional tax will the firm owe if its marginal tax rate is 25%? A. $3.75 B. $7.50 C. $13.75 D. $25.00 Increase in taxes = 0.25 × ($100 − 85) = $3.75

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

95.

According to the U.S. tax code at the beginning of 2016, the highest marginal tax rate for personal taxpayers is: A. 25.0%. B. 28.5%. C. 35.0%. D. 39.6%. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

96.

Which one of the following statements is correct for a corporation with a negative net income in both the present and the last fiscal year? A. This year's loss can be carried back, but last year's loss cannot be used. B. Neither of the losses can be used to reduce taxes. C. Both losses can be carried forward but not backward. D. Both losses can be carried forward and backward, within certain time limits. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

97.

Assume a single taxpayer is taxed at 10% on the first $9,275 of taxable income, 15% on the next $28,375 of income, and at 25% for the following $53,500 of income. What is the average tax rate for that individual if her taxable income is $42,000? A. 14.93% B. 16.67% C. 16.13% D. 25% Tax = (0.1 × 9,275) + (0.15 × 28,375) + (0.25 × (42,000 − 9,275 − 28,375)) = $6,271.25. Average tax rate= $6,271.25/$42,000 = 0.1493, or 14.93%.

98.

An individual's income for the year includes both dividend and interest payments. Which of these statements correctly applies to that individual's tax liability? A. Dividends are taxed; tax on interest payments is paid at the corporate level. B. Interest is taxed; tax on dividend payments is paid at the corporate level. C. Both dividend and interest payments are taxed at the personal level. D. All taxes on dividend and interest payments are paid at the corporate level. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

99.

A major goal of the Sarbanes-Oxley Act is to: A. increase transparency in the financial reporting of a firm's activities. B. require firms to provide common-size balance sheets to shareholders. C. lower corporate tax rates. D. require U.S. firms to abide by international accounting standards. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows. Topic: Ethics, governance, and regulation

100.

Which one of the following is not a requirement imposed by the Sarbanes-Oxley Act? A. Accounting firms may not offer other services to companies they audit. B. Any one individual is prohibited from serving as the chairman of a firm's board of directors for more than 5 years. C. A board's audit committee must consist of directors who are independent of the firm's management. D. Management must certify that the financial statements present a fair view of the firm's financial position. AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Ethics, governance, and regulation

101.

Who pays taxes on earnings distributed as dividends? A. The issuing corporation B. The shareholder receiving the dividend C. Both the issuing corporation and the shareholder D. Neither the issuing corporation nor the shareholder AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

102.

Assume tax rates on single individuals are 10% on taxable income up to $9,275, 15% on income of $9,276 to $37,650 and 25% on income of $37,651 to $91,150. What is the tax liability for a single individual with $52,000 of taxable income, which includes $2,000 of dividends? A. $8,771.25 B. $9,103.50 C. $8,603.50 D. $8,356.25 (0.10 × $9,275) + (0.15 × $28,375) + (0.25 × $14,350) = $8,771.25

103.

Which of the following forms of income can individuals defer from taxation? A. Dividends B. Interest C. Realized capital gains D. Unrealized capital gains AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

104.

Which type of income is subject to "double taxation"? A. Dividends and wages B. Capital gains C. Dividends D. Wages AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

105.

Professor Diehard found an effective antibiotic for the DEPRESS bacteria, and patented the drug. He believes that he could sell the patent for $20 million. He then formed a corporation and invested $400,000 in setting up a production plant. There are 2 million shares of stock outstanding. If the professor's belief is correct, what would be the price per share and the book value per share? A. $10.20; $0.20 B. $10.00; $0.20 C. $9.80; $0.40 D. $9.80; $0.20 Book value equals the $400,000 Professor Diehard has contributed in tangible assets. Market value equals the value of his patent plus the value of the production plant, or $20.4 million. Price per share = $20.4 million/2 million shares = $10.20. Book value per share = $400,000/2 million shares = $0.20.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 03-02 Distinguish between market and book values. Topic: Market and book values

106.

You have gathered this information on a firm: $500,000 sales, $10,000 cash dividends, $300,000 cost of goods sold, $20,000 administrative expense, $20,000 depreciation expense, $40,000 interest expense, $10,000 purchase of productive equipment, no changes in working capital, and a tax rate of 35%. What is the free cash flow? A. $141,000 B. $168,000 C. $128,000 D. $142,000 Net income = ($500,000 − 300,000 − 20,000 − 20,000 − 40,000) × (1 − 0.35) = $78,000 Cash flow from operations = $78,000 + 40,000 + 20,000 = $138,000 Free cash flow = $138,000 − 10,000 = $128,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 03-03 Explain why income differs from cash flow. Topic: Free cash flow

107.

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

108.

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

109.

What are the average and marginal tax rates for a corporation that has $97,648 of taxable income? The tax rates are as follows: A. 21.97%; 25% B. 21.97%; 34% C. 23.08%; 34% D. 34%; 34% Average tax rate = $21,450.32/$97,648 = 0.2197, or 21.97% Marginal tax rate = 34%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium

Gradable: automatic Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income. Topic: Taxes

110.

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

Chapter 03 Test Bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Ethics

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

110

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

110

Learning Objective: 03-01 Interpret the information contained in the balance sheet; income statement; and statement of cash flows.

Learning Objective: 03-02 Distinguish between market and book values.

Learning Objective: 03-03 Explain why income differs from cash flow.

Learning Objective: 03-04 Understand the essential features of the taxation of corporate and personal income.

Topic: Balance sheet

Topic: Depreciation

Topic: Ethics, governance, and regulation

Topic: Financing activities

Topic: Free cash flow

Topic: Generally Accepted Accounting Principles (GAAP)

Topic: Income statement

Topic: Investing activities

Topic: Liquidity

Topic: Market and book values

Topic: Net working capital

Topic: Noncash items

Topic: Operating activities

Topic: Sources and uses of cash

Topic: Standardized financial statements

Topic: Statement of cash flows

Topic: Taxes

Chapter 04 Test Bank - Static Student: ___________________________________________________________________________

The income statement of a firm shows the value of its assets and liabilities over a specified period of time. True

The higher the times interest earned ratio, the higher the interest expense. True

False

The inventory turnover ratio times the average days in inventory equals 365. True

False

The asset turnover ratio and inventory turnover ratio are both efficiency ratios. True

False

The net working capital to total assets ratio is always a larger number than the current ratio. True

False

Net working capital to total assets and current ratio are both liquidity ratios. True

False

Net working capital is determined from the difference between current assets and current liabilities. True

False

The net working capital of a firm will decrease when unpaid bills from suppliers are later paid with cash. True

False

Return on assets and return on equity are both profitability ratios. True

False

10. Return on assets is always a larger number than the return on equity. True

False

11. The reduction in value over time of intangible assets is known as amortization. True

False

12. Receivable turnover ratio and asset turnover ratio are both efficiency ratios. True

False

13. Market value added is the difference between the market value of the firm's equity and its book value. True

False

14. Market value added is the same as economic value added. True

False

15. The difference between the current and quick ratios is that inventory has been subtracted from current assets. True

False

16. A healthy current ratio and an unhealthy quick ratio may be caused by excess inventory. True

False

17. Other things equal, an increase in average accounts receivable will increase a firm's return on assets. True

False

18. Residual income is another term for economic value added. True

False

19. EVA is the net profit of the firm adjusted for the cost of capital. True

False

20. ROE is equal to ROC when the firm has no debt. True

False

21. Increasing leverage will always act to increase a firm's ROE. True

False

22. Which of the following is the least effective measure of operating performance? A. ROC B. ROA C. ROE D. All of the options are equally ineffective measures of operating performance. 23. Lease obligations are included in certain leverage ratios because leases: A. require the payment of interest. B. represent long-term fixed obligations. C. must be financed through a bank. D. are perpetual obligations.

24. A firm with no leases has a long-term debt ratio of 50%. This means that the book value of equity: A. equals the book value of long-term debt. B. is less than the book value of long-term debt. C. is greater than the book value of long-term debt. D. is unknown in relation to the book value of long-term debt. 25. When a firm's long-term debt-equity ratio is .98, the firm: A. has too much long-term debt in relation to leases. B. has less long-term debt than equity. C. is nearing insolvency. D. has as much in long-term liabilities as in equity. 26. If a firm's debt ratio is greater than 0.5, then: A. its current liabilities are quite high. B. its debt-equity ratio exceeds 1.0. C. it has too few total assets. D. it has more long-term debt than equity. 27. A times interest earned ratio of 5 indicates the firm: A. pays 5 times its earnings in interest expense. B. earns significantly more than its interest obligations. C. has interest expense equal to 5% of EBIT. D. has a low tax liability. 28. If a firm's cash coverage ratio is greater than its times interest earned ratio, then the: A. firm's assets are not fully depreciated. B. firm has no lease obligations. C. firm has very little long-term debt. D. firm has a high degree of liquidity. 29. An asset's liquidity measures its: A. potential for generating a profit. B. cash requirements. C. ease and cost of being converted to cash. D. proportion of debt financing. 30. Which of the following actions could improve a firm's current ratio if it is now less than 1.0? A. Converting marketable securities to cash B. Paying accounts payable with cash C. Buying inventory on credit D. Selling inventory at cost

31. If a firm's quick ratio is equal to its current ratio: A. It has a low level of current liabilities. B. It has no inventory. C. It faces a potentially serious liquidity crisis. D. It is in a loss-making position. 32. A firm has $600,000 in current assets and $150,000 in current liabilities. Which of the following is correct if it uses cash to pay off $50,000 in accounts payable? A. Current ratio will increase to 5.0. B. Net working capital will increase to $500,000. C. Current ratio will decrease. D. Net working capital will not change. 33. How would you interpret an inventory turnover ratio of 10.7? A. It takes 50 days on average to collect receivables. B. Inventory is converted into sales every 50 days. C. The firm has sufficient inventories to maintain sales for 34.1 days. D. Assets are converted into sales every 50 days. 34. What are the annual sales for a firm with $400,000 in debt, a total debt ratio of 0.4, and an asset turnover of 3? A. $333,333 B. $1,200,000 C. $1,800,000 D. $3,000,000 35. Which one of the following will cause a reduction in the NWC turnover ratio all else held constant? A. A decrease in sales B. An increase in average payables C. An increase in average inventory D. An increase in the average cash balance 36. The inventory turnover ratio compares: A. current assets to inventory. B. cost of goods sold to inventory. C. average receivables to inventory. D. average assets to inventory. 37. When Tri-C Corp. compares its ratios to industry averages, it has a higher current ratio, an average quick ratio, and a lower inventory turnover. What might you assume about Tri-C? A. Its cash balance is relatively low. B. Its cost of goods sold is relatively low. C. Its current liabilities are relatively low. D. Its average inventory is relatively high.

38. Which one of the following statements is most likely correct for a firm with an average collection period of 90 days? A. Its average daily sales are low. B. Its average daily sales are high. C. Its current ratio will be high. D. It is providing financing for approximately 25% of its annual sales. 39. An all-equity firm reports a net profit margin of 10% on sales of $3 million. If the tax rate is 40%, what is the pretax profit A. $100,000 B. $300,000 C. $500,000 D. $800,000 40. Which of the following will allow your firm to achieve its targeted 16% ROA with an asset turnover of 2.5? A. A leverage ratio of .0667 B. A P/E ratio of 14 C. A return on equity of 25% D. An operating profit margin of 6.4% 41. What is the ROA of a firm with $150,000 in receivables, which represents 60 days sales, assets of $750,000, and an operating profit margin of 9%? A. 7.50% B. 9.00% C. 10.95% D. 16.70% 42. Last year's return on equity was 30%. This year the ROE has decreased to 20% even though the firm's earnings equaled last year's earnings. The firm has no preferred stock. What caused the decrease? A. Equity decreased by 10%. B. Equity decreased by 50%. C. Equity increased by 10%. D. Equity increased by 50%. 43. Which one of these costs accounts for the difference between accounting income and economic value added? A. Depreciation B. Cost of capital C. Taxes D. Dividends 44. After-tax operating income for a leveraged firm is defined as: A. net income + after-tax interest. B. EBIT × (1 − tax rate). C. net income + depreciation. D. profit margin × sales.

45. Which one of these changes indicates an improvement in a firm's asset management efficiency? A. An increase in the amount of assets per dollar of sales B. An increase in the inventory turnover rate C. A decrease in the receivables turnover rate D. An increase in the average days in inventory 46. What is the market price of a share of stock for a firm with 100,000 shares outstanding, a book value of equity of $3,000,000, and a market-to-book ratio of 3? A. $10 B. $30 C. $90 D. $105 47. Which one of the following may be the best measure of company performance since it accounts for the opportunity cost of capital? A. EVA B. Net income C. Increase in sales D. Current ratio 48. Which one of these statements is correct? A. Market value added measures the difference between the total market value and the total book value of equity. B. Net income is also called economic value added. C. EVA measures the net profit of a firm after deducting the cost of the assets used in the production process. D. EVA considers the cost of long-term debt financing but excludes the cost of equity financing. 49. The board of directors is dissatisfied with last year's ROE of 15%. If the operating profit margin and asset turnover ratio remain unchanged at 8% and 1.25, respectively, by how much must the leverage ratio (i.e., assets/equity) increase to achieve 20% ROE? A. 0.50% B. 5% C. 16.67% D. 33.33% 50. What must happen to asset turnover to leave ROE unchanged from its original 16% level if the operating profit margin is reduced from 8% to 6% and the leverage ratio increases from 1.2 to 1.6? Asset turnover must: A. remain constant. B. increase from 1.46 to 2.33. C. decrease from 1.74 to 1.67. D. increase from 1.38 to 1.67.

51. The use of debt in the firm's capital structure will increase ROE if the firm: A. has more debt than equity. B. pays less in taxes than in interest. C. earns a higher return than the rate paid on debt. D. has a times interest earned ratio greater than 1.0. 52. To calculate which of these measures do you need to know the cost of capital? A. ROC. B. ROA. C. ROE. D. EVA. 53. A corporation declares $25 million in net income, $1 million in preferred stock dividends, and $7 million in common stock dividends. By how much will shareholders' equity increase on the balance sheet? A. $17 million B. $18 million C. $19 million D. $25 million 54. If a firm starts the year with receivables of $80,000 and produces sales for the year of $300,000, what is its average collection period? A. 3.75 days. B. 97.3 days. C. 52 days. D. 77.9 days 55. A firm's after-tax operating income was $1,000,000 in 2016. It started the year with total capital of $8,000,000 and raised an additional $1 million of capital during the year. The additional capital raised during 2016 only started to affect the operating income in 2017. Which value best represents the return on capital for 2016? A. 12.5% B. 11.8% C. 11.1% D. 10.0% 56. If ROC is less than a firm's cost of capital, which of the following must be true? A. The firm's EVA is positive. B. The firm's EVA is negative. C. The firm's ROE is equal to zero. D. The firm's ROE is negative. 57. When will ROE equal ROC? A. Whenever the firm has equal debt and equity financing B. Whenever the firm has no debt C. Whenever the value of the firm's assets exceeds the value of its equity D. ROE will never equal ROC

58. If the ratio of total liabilities to total assets is 0.5, long-term liabilities are $3,000, and equity is $5,000, then:: A. you know that current liabilities must be $ 2,000. B. you know that current assets must be $400. C. you know that retained earnings must be $800. D. you know that preferred stock must be $400. 59. What is the debt ratio for a firm with a debt-equity ratio of 0.5? A. 35% B. 33.3% C. 54% D. 66.7% 60. Which one of the following will increase a firm's times interest earned ratio? A. An increase in debt B. A decrease in cost of goods sold C. An increase in interest expense D. A decrease in net income 61. Which one of the following would be most detrimental to a firm's current ratio if that ratio is currently 2? A. Collecting payment on an accounts receivable B. Selling marketable securities at cost C. Paying off accounts payable with cash D. Purchasing inventory on credit 62. A retail store with zero net working capital has: A. no cash or marketable securities. B. insufficient inventory. C. no current debt. D. a quick ratio that is less than 1. 63. A deficiency of the standard measures of liquidity is that the measures: A. ignore a firm's reserve borrowing capacity. B. fail to include accounts receivable as an asset. C. give inventories equal weighting in the quick ratio. D. do not include the current portions of long-term debt. 64. A firm has average daily expenses of $2.13 million and average accounts payable of $112.7 million. On average, how many days does it take the firm to pay its bills? A. 63.47 days B. 52.91 days C. 48.19 days D. 59.03 days

65. If a company has a healthy current ratio but a significantly lower quick ratio, then you can assume that: A. the cost of goods sold represents more than half of sales. B. current liabilities exceed current assets. C. the firm sells only on a cash basis. D. inventory represents a large portion of the firm's current assets. 66. Last year's asset turnover ratio was 2.0. Sales have increased by 25% and total assets have increased by 10% since that time. What is the current asset turnover ratio? A. 1.82 B. 2.05 C. 2.15 D. 2.27 67. What is the inventory turnover ratio for ABC Corp. if cost of goods sold equals $5,000, current ratio equals 3, quick ratio equals 1.5, and the firm has $1,800 in current assets? A. 2.78 times B. 4.17 times C. 5.56 times D. 8.33 times 68. Assume BDS acquired its main supplier, ABC. As a result of the acquisition, BDS finds that its profit margin increased but its ROA remained constant. A decrease in which one of these ratios is most apt to be the reason why the ROA did not increase with the increase in the profit margin? A. Leverage ratio B. Market-to-book ratio C. Asset turnover D. Debt burden 69. A firm's operating profit margin is 20% with an EBIT of $1.5 million and sales of $5 million. If it has no debt, how much did the firm pay in taxes? A. $50,000 B. $300,000 C. $350,000 D. $500,000 70. What is primarily responsible for the potential distortion among the ROA of different firms when net income is used in the numerator of ROA? A. Firms have different dividend payout ratios. B. Some firms use fully depreciated assets. C. Financial leverage varies among firms. D. Unprofitable firms will not have any tax liability.

71. Which one of the following changes will provide an increase in a firm's ROE? A. A decrease in the profit margin B. An increase in the interest rate C. An increase in equity D. A decrease in the tax rate 72. An increase in which one of the following will have no effect on the cash coverage ratio? A. Depreciation B. Interest C. Sales D. Cost of goods sold 73. What is the book value per share for a firm with 2 million shares outstanding at a price of $50, a market-to-book ratio of 0.75, and a dividend-payout ratio of 50%? A. $33.33 B. $37.50 C. $62.50 D. $66.67 74. What is the residual income for a firm that is entirely equity-financed with $1 million in capital, $300,000 in net income, and a 20% cost of capital? A. $100,000 B. $140,000 C. $240,000 D. $500,000 75. By how much must a firm reduce its assets in order to improve ROA from 10% to 12% if the firm's operating profit margin is 5% on sales of $4 million? Assume that the reduction in assets has no effect on sales or profit margin A. $240,000 B. $333,333 C. $400,000 D. $516,167 76. What is the ROE for a firm with a times interest earned ratio of 2, a tax liability of $1 million, and interest expense of $1.5 million if equity equals $1.5 million? A. 26.67% B. 30.00% C. 33.33% D. 50.00%

77. Which of the following choices would be guaranteed to increase a firm's ROE if the ROA is currently 10% and the leverage ratio equals 1? A. Decrease the leverage ratio B. Increase the debt burden from its current level C. Decrease assets from the current level D. Decrease the debt burden from its current level 78. XYZ Corp. has an operating profit margin of 7%, a debt burden of .8, and has financed two-thirds of its assets through equity. What asset turnover ratio is necessary to achieve an ROE of 18%? A. 1.26 B. 1.61 C. 2.14 D. 4.02 79. The use of financial leverage will be detrimental to a firm's ROE if the: A. firm currently has no long-term debt. B. firm's current ratio is greater than 1. C. interest expense exceeds the tax liability. D. interest rate on debt exceeds the firm's ROA. 80. Efficiency ratios: A. include the quick ratio, asset turnover ratio, and return on equity. B. are used to measure how well the company uses its assets. C. are used to measure how liquid the company is. D. measure the profits generated by a firm's equity and assets. 81. A total debt ratio of 0.35: A. indicates that the firm is financed with 35% long-term debt. B. would exist if a firm had liabilities of $700 and assets of $2,000. C. indicates that 35 cents of every dollar of capital is in the form of short-term debt. D. indicates that 35 cents of every dollar of capital is in the form of long-term debt. 82. A company has total assets of $1,000, current liabilities of $130, and total liabilities of $350. If debt is the only long-term liability, what is the long-term debt ratio? A. 0.19 B. 0.25 C. 0.36 D. 0.31 83. If the cash coverage ratio exceeds the times interest earned ratio, then the firm has: A. a positive cash flow. B. depreciable assets. C. no long-term debt. D. short-term debts.

84. Instead of increasing its long-term debt by borrowing money from a bank to purchase new stereo equipment, Jay's Jams Inc. decides to lease the equipment on a long-term basis. How will the long-term debt ratio differ if the lease option is selected over the bank-debt option? A. The ratio will be lower under the leasing option. B. The ratio will be higher under the leasing option. C. The ratio will be the same regardless of the financing method selected. D. The ratio effects are unknown without the amount of the lease obligation. 85. Which of these assets is generally considered to be the most liquid? A. Buildings B. Land C. Finished goods inventory D. Accounts receivable 86. High levels of liquidity may indicate: A. low levels of net working capital. B. low profit margins. C. high levels of economic value added. D. inefficient use of assets. 87. The current ratio is a good proxy for a firm's: A. liquidity. B. efficiency. C. degree of leverage. D. profitability. 88. If a company uses cash to pay off some of its accounts payables, what effect will this have on its liquidity ratios, given that the ratios exceeded 1 before the payoff? A. The quick ratio and current ratio will both increase. B. The quick ratio and current ratio will both decrease. C. The quick ratio will increase but the current ratio will remain unchanged. D. The current ratio will increase but the quick ratio will remain unchanged. 89. TSI Inc. has liquid assets of $1,000, enough to finance its operations for 67 days. TSI's average daily expenditures from operations are: A. $6.70. B. $8.23. C. $14.93. D. $22.28.

90. An asset turnover ratio of 1.75 can be interpreted as: A. $1.75 in sales are generated by every $1 of assets. B. $1.75 in additional assets are generated by every $1 of sales. C. $1.75 in assets are used to generate $1 of sales. D. $1 in sales are used to generate $1.75 in assets. 91. Which of these indicates that a firm is efficient? A. A high average collection period B. A high day's sales in inventories C. A low asset turnover D. A high inventory turnover 92. Calculate the average collection period for Dots Inc. if its accounts receivables were $550 at the beginning of a year in which the firm generated $3,000 of sales? A. 60 days B. 61 days C. 67 days D. 73 days 93. Which one of these ratios is commonly referred to as the acid-test ratio? A. Times interest earned ratio B. Quick ratio C. Cash coverage ratio D. Cash ratio 94. Balsco's balance sheet shows total assets of $238,000 and total liabilities of $107,000. The firm has 55,000 shares of stock outstanding that sell for $11 a share. What is amount of market value added? A. $389,000 B. $474,000 C. $1,073,000 D. $123,712 95. What will be Gamma Inc.'s return on equity if total asset turnover is 0.85, operating profit margin is 0.15, two-thirds of its assets are financed through equity, and debt burden is 0.6?

A. 9.56% B. 11.48% C. 16.96% D. 38.25%

96. Which of the following is not a problem with EVA? A. EVA cannot be used to measure the profitability of a private company B. EVA cannot be used to compare the effectiveness of managers with different amounts of assets under their control C. EVA assumes that the book values of assets are equal to their current worth D. EVA assumes that you know the cost of capital 97. In the past year, TVG had revenues of $3 million, cost of goods sold of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt outstanding with a face value of $1million, market value of $.92 million, and a coupon rate of 8%. What is the firm's times interest earned ratio? A. 3.75 B. 2.98 C. 2.80 D. 3.40

Chapter 04 Test Bank - Static Key 1.

The income statement of a firm shows the value of its assets and liabilities over a specified period of time. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Income statement

The higher the times interest earned ratio, the higher the interest expense. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

The net working capital of a firm will decrease when unpaid bills from suppliers are later paid with cash. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Net working capital

Net working capital is determined from the difference between current assets and current liabilities. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Net working capital

Net working capital to total assets and current ratio are both liquidity ratios. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember

Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

The net working capital to total assets ratio is always a larger number than the current ratio. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

The asset turnover ratio and inventory turnover ratio are both efficiency ratios. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

The inventory turnover ratio times the average days in inventory equals 365. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

Return on assets and return on equity are both profitability ratios. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

10.

Return on assets is always a larger number than the return on equity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic

Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

11.

The reduction in value over time of intangible assets is known as amortization. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Topic: Depreciation methods

12.

Receivable turnover ratio and asset turnover ratio are both efficiency ratios. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

13.

Market value added is the difference between the market value of the firm's equity and its book value. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation. Topic: Market value ratios

14.

Market value added is the same as economic value added. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Market value ratios

15.

The difference between the current and quick ratios is that inventory has been subtracted from current assets. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity.

Topic: Short-term solvency ratios

16.

A healthy current ratio and an unhealthy quick ratio may be caused by excess inventory. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

17.

Other things equal, an increase in average accounts receivable will increase a firm's return on assets. FALSE AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

18.

Residual income is another term for economic value added. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

19.

EVA is the net profit of the firm adjusted for the cost of capital. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

20.

ROE is equal to ROC when the firm has no debt. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital,

assets, and equity. Topic: Profitability ratios

21.

Increasing leverage will always act to increase a firm's ROE. FALSE AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

22.

Which of the following is the least effective measure of operating performance? A. ROC B. ROA C. ROE D. All of the options are equally ineffective measures of operating performance. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

23.

Lease obligations are included in certain leverage ratios because leases: A. require the payment of interest. B. represent long-term fixed obligations. C. must be financed through a bank. D. are perpetual obligations. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

24.

A firm with no leases has a long-term debt ratio of 50%. This means that the book value of equity: A. equals the book value of long-term debt. B. is less than the book value of long-term debt. C. is greater than the book value of long-term debt. D. is unknown in relation to the book value of long-term debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity.

Topic: Long-term solvency ratios

25.

When a firm's long-term debt-equity ratio is .98, the firm: A. has too much long-term debt in relation to leases. B. has less long-term debt than equity. C. is nearing insolvency. D. has as much in long-term liabilities as in equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

26.

If a firm's debt ratio is greater than 0.5, then: A. its current liabilities are quite high. B. its debt-equity ratio exceeds 1.0. C. it has too few total assets. D. it has more long-term debt than equity. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

27.

A times interest earned ratio of 5 indicates the firm: A. pays 5 times its earnings in interest expense. B. earns significantly more than its interest obligations. C. has interest expense equal to 5% of EBIT. D. has a low tax liability. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

28.

If a firm's cash coverage ratio is greater than its times interest earned ratio, then the: A. firm's assets are not fully depreciated. B. firm has no lease obligations. C. firm has very little long-term debt. D. firm has a high degree of liquidity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic

Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

29.

An asset's liquidity measures its: A. potential for generating a profit. B. cash requirements. C. ease and cost of being converted to cash. D. proportion of debt financing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Liquidity

30.

Which of the following actions could improve a firm's current ratio if it is now less than 1.0? A. Converting marketable securities to cash B. Paying accounts payable with cash C. Buying inventory on credit D. Selling inventory at cost AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

31.

If a firm's quick ratio is equal to its current ratio: A. It has a low level of current liabilities. B. It has no inventory. C. It faces a potentially serious liquidity crisis. D. It is in a loss-making position. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

32.

A firm has $600,000 in current assets and $150,000 in current liabilities. Which of the following is correct if it uses cash to pay off $50,000 in accounts payable? A. Current ratio will increase to 5.0. B. Net working capital will increase to $500,000. C. Current ratio will decrease. D. Net working capital will not change. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Net working capital

33.

How would you interpret an inventory turnover ratio of 10.7? A. It takes 50 days on average to collect receivables. B. Inventory is converted into sales every 50 days. C. The firm has sufficient inventories to maintain sales for 34.1 days. D. Assets are converted into sales every 50 days. Days' sales in inventory = 365 days / 10.7 = 34.1 days

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

34.

What are the annual sales for a firm with $400,000 in debt, a total debt ratio of 0.4, and an asset turnover of 3? A. $333,333 B. $1,200,000 C. $1,800,000 D. $3,000,000 Total debt ratio = Total debt / Total assets, so: Assets = $400,000 / 0.4 = $1,000,000 Asset turnover ratio = Sales / Total assets, so: Sales = $1,000,000 × 3 = $3,000,000

35.

Which one of the following will cause a reduction in the NWC turnover ratio all else held constant? A. A decrease in sales B. An increase in average payables C. An increase in average inventory D. An increase in the average cash balance AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

36.

The inventory turnover ratio compares: A. current assets to inventory. B. cost of goods sold to inventory. C. average receivables to inventory. D. average assets to inventory. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

37.

When Tri-C Corp. compares its ratios to industry averages, it has a higher current ratio, an average quick ratio, and a lower inventory turnover. What might you assume about Tri-C? A. Its cash balance is relatively low. B. Its cost of goods sold is relatively low. C. Its current liabilities are relatively low. D. Its average inventory is relatively high. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Evaluate Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-05 Compare a company's financial standing with its competitors and its own position in previous years. Topic: Short-term solvency ratios

38.

Which one of the following statements is most likely correct for a firm with an average collection period of 90 days? A. Its average daily sales are low. B. Its average daily sales are high. C. Its current ratio will be high. D. It is providing financing for approximately 25% of its annual sales. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

39.

An all-equity firm reports a net profit margin of 10% on sales of $3 million. If the tax rate is 40%, what is the pretax profit A. $100,000 B. $300,000 C. $500,000 D. $800,000 Net profit margin = Net profit margin = (Pretax income − Taxes) / Sales 0.10 = (1 − 0.4) × Pretax income / $3,000,000 → Pretax income = $500,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Topic: Profitability ratios

40.

Which of the following will allow your firm to achieve its targeted 16% ROA with an asset turnover of 2.5? A. A leverage ratio of .0667 B. A P/E ratio of 14 C. A return on equity of 25% D. An operating profit margin of 6.4% ROA = Operating profit margin × Asset turnover 0.16 = Operating profit margin × 2.50 Operating profit margin = 0.064, or 6.4%

41.

What is the ROA of a firm with $150,000 in receivables, which represents 60 days sales, assets of $750,000, and an operating profit margin of 9%? A. 7.50% B. 9.00% C. 10.95% D. 16.70% Sales = ($150,000 / 60) × 365 = $912,500 ROA = Operating profit margin × Asset turnover = 0.09 × ($912,500 / $750,000) = 0.1095, or 10.95%

42.

Last year's return on equity was 30%. This year the ROE has decreased to 20% even though the firm's earnings equaled last year's earnings. The firm has no preferred stock. What caused the decrease? A. Equity decreased by 10%. B. Equity decreased by 50%. C. Equity increased by 10%. D. Equity increased by 50%. NI = 0.3(Old equity) NI = 0.2(Old equity + New equity) 0.3(Old equity) = 0.2(Old equity + New equity) New equity = 0.5 Old equity

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

43.

Which one of these costs accounts for the difference between accounting income and economic value added? A. Depreciation B. Cost of capital C. Taxes D. Dividends AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

44.

After-tax operating income for a leveraged firm is defined as: A. net income + after-tax interest. B. EBIT × (1 − tax rate). C. net income + depreciation. D. profit margin × sales. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

45.

Which one of these changes indicates an improvement in a firm's asset management efficiency? A. An increase in the amount of assets per dollar of sales B. An increase in the inventory turnover rate C. A decrease in the receivables turnover rate D. An increase in the average days in inventory AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

46.

What is the market price of a share of stock for a firm with 100,000 shares outstanding, a book value of equity of $3,000,000, and a market-to-book ratio of 3? A. $10 B. $30 C. $90 D. $105 Market price per share = ($3,000,000 / 100,000) × 3 = $90

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation. Topic: Market value ratios

47.

Which one of the following may be the best measure of company performance since it accounts for the opportunity cost of capital? A. EVA B. Net income C. Increase in sales D. Current ratio AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

48.

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

49.

The board of directors is dissatisfied with last year's ROE of 15%. If the operating profit margin and asset turnover ratio remain unchanged at 8% and 1.25, respectively, by how much must the leverage ratio (i.e., assets/equity) increase to achieve 20% ROE? A. 0.50% B. 5% C. 16.67% D. 33.33% Last year: ROE = leverage ratio × asset turnover × operating profit margin 0.15 = leverage ratio × 1.25 × 0.08 Leverage ratio = 1.5 This year: ROE = leverage ratio × asset turnover × operating profit margin 0.20 = leverage ratio × 1.25 × 0.08 Leverage ratio = 2 Percentage increase = (2 - 1.5) / 1.5 = 0.3333, or 33.33%

50.

What must happen to asset turnover to leave ROE unchanged from its original 16% level if the operating profit margin is reduced from 8% to 6% and the leverage ratio increases from 1.2 to 1.6? Asset turnover must: A. remain constant. B. increase from 1.46 to 2.33. C. decrease from 1.74 to 1.67. D. increase from 1.38 to 1.67. Original: ROE = leverage ratio × asset turnover × operating profit margin 0.16 = 1.2 × asset turnover × 0.08 Asset turnover = 1.67 New: 0.16 = 1.6 × asset turnover × 0.06 Asset turnover = 1.67

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. Topic: DuPont identity

51.

The use of debt in the firm's capital structure will increase ROE if the firm: A. has more debt than equity. B. pays less in taxes than in interest. C. earns a higher return than the rate paid on debt. D. has a times interest earned ratio greater than 1.0. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

52.

To calculate which of these measures do you need to know the cost of capital? A. ROC. B. ROA. C. ROE. D. EVA. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

53.

A corporation declares $25 million in net income, $1 million in preferred stock dividends, and $7 million in common stock dividends. By how much will shareholders' equity increase on the balance sheet? A. $17 million B. $18 million C. $19 million D. $25 million AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Income statement

54.

If a firm starts the year with receivables of $80,000 and produces sales for the year of $300,000, what is its average collection period? A. 3.75 days. B. 97.3 days. C. 52 days. D. 77.9 days AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Collection Policy

55.

A firm's after-tax operating income was $1,000,000 in 2016. It started the year with total capital of $8,000,000 and raised an additional $1 million of capital during the year. The additional capital raised during 2016 only started to affect the operating income in 2017. Which value best represents the return on capital for 2016? A. 12.5% B. 11.8% C. 11.1% D. 10.0% ROC = $1,000,000 / $8,000,000 = 0.125, or 12.5%

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital,

assets, and equity. Topic: Profitability ratios

56.

If ROC is less than a firm's cost of capital, which of the following must be true? A. The firm's EVA is positive. B. The firm's EVA is negative. C. The firm's ROE is equal to zero. D. The firm's ROE is negative. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

57.

When will ROE equal ROC? A. Whenever the firm has equal debt and equity financing B. Whenever the firm has no debt C. Whenever the value of the firm's assets exceeds the value of its equity D. ROE will never equal ROC AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

58.

If the ratio of total liabilities to total assets is 0.5, long-term liabilities are $3,000, and equity is $5,000, then:: A. you know that current liabilities must be $ 2,000. B. you know that current assets must be $400. C. you know that retained earnings must be $800. D. you know that preferred stock must be $400. Total liabilities / total assets = (long-term liabilities + current liabilities) / (long-term liabilities + current liabilities + equity) 0.5 = ($3,000 + current liabilities) / ($3,000 + current liabilities + $5,000) Current liabilities = $2,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

59.

What is the debt ratio for a firm with a debt-equity ratio of 0.5? A. 35% B. 33.3% C. 54% D. 66.7% If debt / equity = 0.5, then debt / (debt + equity) = 0. 5 / 1.5 = 0.333, or 33.3%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

60.

Which one of the following will increase a firm's times interest earned ratio? A. An increase in debt B. A decrease in cost of goods sold C. An increase in interest expense D. A decrease in net income AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

61.

Which one of the following would be most detrimental to a firm's current ratio if that ratio is currently 2? A. Collecting payment on an accounts receivable B. Selling marketable securities at cost C. Paying off accounts payable with cash D. Purchasing inventory on credit AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

62.

A retail store with zero net working capital has: A. no cash or marketable securities. B. insufficient inventory. C. no current debt. D. a quick ratio that is less than 1. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

63.

A deficiency of the standard measures of liquidity is that the measures: A. ignore a firm's reserve borrowing capacity. B. fail to include accounts receivable as an asset. C. give inventories equal weighting in the quick ratio. D. do not include the current portions of long-term debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

64.

A firm has average daily expenses of $2.13 million and average accounts payable of $112.7 million. On average, how many days does it take the firm to pay its bills? A. 63.47 days B. 52.91 days C. 48.19 days D. 59.03 days $112.7m / $2.13m = 52.91 days

65.

If a company has a healthy current ratio but a significantly lower quick ratio, then you can assume that: A. the cost of goods sold represents more than half of sales. B. current liabilities exceed current assets. C. the firm sells only on a cash basis. D. inventory represents a large portion of the firm's current assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

66.

Last year's asset turnover ratio was 2.0. Sales have increased by 25% and total assets have increased by 10% since that time. What is the current asset turnover ratio? A. 1.82 B. 2.05 C. 2.15 D. 2.27 Asset turnover = sales / total assets = 2 2 × 1.25 / 1.1 = 2.27

67.

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

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard

Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

68.

Assume BDS acquired its main supplier, ABC. As a result of the acquisition, BDS finds that its profit margin increased but its ROA remained constant. A decrease in which one of these ratios is most apt to be the reason why the ROA did not increase with the increase in the profit margin? A. Leverage ratio B. Market-to-book ratio C. Asset turnover D. Debt burden AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: DuPont identity

69.

A firm's operating profit margin is 20% with an EBIT of $1.5 million and sales of $5 million. If it has no debt, how much did the firm pay in taxes? A. $50,000 B. $300,000 C. $350,000 D. $500,000 Without any interest expense, the operating profit margin can be computed as: Operating profit margin = (EBIT − taxes) / sales 0.20 = ($1,500,000 − taxes) / $5,000,000 Taxes = $500,000

70.

What is primarily responsible for the potential distortion among the ROA of different firms when net income is used in the numerator of ROA? A. Firms have different dividend payout ratios. B. Some firms use fully depreciated assets. C. Financial leverage varies among firms. D. Unprofitable firms will not have any tax liability. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

71.

Which one of the following changes will provide an increase in a firm's ROE? A. A decrease in the profit margin B. An increase in the interest rate C. An increase in equity D. A decrease in the tax rate

72.

An increase in which one of the following will have no effect on the cash coverage ratio? A. Depreciation B. Interest C. Sales D. Cost of goods sold AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

73.

What is the book value per share for a firm with 2 million shares outstanding at a price of $50, a market-to-book ratio of 0.75, and a dividend-payout ratio of 50%? A. $33.33 B. $37.50 C. $62.50 D. $66.67 Market-to-book ratio = stock price / book value per share 0.75 = $50 / book value per share Book value per share = $66.67

74.

What is the residual income for a firm that is entirely equity-financed with $1 million in capital, $300,000 in net income, and a 20% cost of capital? A. $100,000 B. $140,000 C. $240,000 D. $500,000 Residual income = net income − (cost of capital × total capitalization) Residual income = $300,000 − (0.20 × $1,000,000) Residual income = $100,000

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

75.

By how much must a firm reduce its assets in order to improve ROA from 10% to 12% if the firm's operating profit margin is 5% on sales of $4 million? Assume that the reduction in assets has no effect on sales or profit margin A. $240,000 B. $333,333 C. $400,000 D. $516,167 ROA = (sales / assets) × operating profit margin 0.10 = ($4,000,000 / assets) × 0.05 Assets = $2,000,000 0.12 = ($4,000,000 / assets) × 0.05 Assets = $1,666,667 Reduction in assets = $2,000,000 − 1,666,667 Reduction in assets = $333,333

76.

What is the ROE for a firm with a times interest earned ratio of 2, a tax liability of $1 million, and interest expense of $1.5 million if equity equals $1.5 million? A. 26.67% B. 30.00% C. 33.33% D. 50.00% Times interest earned = EBIT / Interest 2 = EBIT / $1,500,000 EBIT = $3,000,000 Net income = EBIT − interest − taxes Net income = $3,000,000 − 1,500,000 − 1,000,000 Net income = $500,000 ROE = net income / equity ROE = $500,000 / $1,500,000 ROE = 0.3333, or 33.33%

77.

Which of the following choices would be guaranteed to increase a firm's ROE if the ROA is currently 10% and the leverage ratio equals 1? A. Decrease the leverage ratio B. Increase the debt burden from its current level C. Decrease assets from the current level D. Decrease the debt burden from its current level AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

78.

XYZ Corp. has an operating profit margin of 7%, a debt burden of .8, and has financed two-thirds of its assets through equity. What asset turnover ratio is necessary to achieve an ROE of 18%? A. 1.26 B. 1.61 C. 2.14 D. 4.02 ROE = leverage ratio × asset turnover × operating profit margin × debt burden 0.18 = (1 / 0.67) × asset turnover × 0.07 × 0.8 Asset turnover = 2.14

79.

The use of financial leverage will be detrimental to a firm's ROE if the: A. firm currently has no long-term debt. B. firm's current ratio is greater than 1. C. interest expense exceeds the tax liability. D. interest rate on debt exceeds the firm's ROA. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Profitability ratios

80.

Efficiency ratios: A. include the quick ratio, asset turnover ratio, and return on equity. B. are used to measure how well the company uses its assets. C. are used to measure how liquid the company is. D. measure the profits generated by a firm's equity and assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

81.

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

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

82.

A company has total assets of $1,000, current liabilities of $130, and total liabilities of $350. If debt is the only long-term liability, what is the long-term debt ratio? A. 0.19 B. 0.25 C. 0.36 D. 0.31 Equity = assets − liabilities Equity = $1,000 − 350 Equity = $650 Long-term debt ratio = long-term debt / (long-term debt + equity) Long-term debt ratio = ($350 − 130) / [($350 − 130) + $650] Long-term debt ratio = 0.25

83.

If the cash coverage ratio exceeds the times interest earned ratio, then the firm has: A. a positive cash flow. B. depreciable assets. C. no long-term debt. D. short-term debts. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

84.

Instead of increasing its long-term debt by borrowing money from a bank to purchase new stereo equipment, Jay's Jams Inc. decides to lease the equipment on a long-term basis. How will the long-term debt ratio differ if the lease option is selected over the bank-debt option? A. The ratio will be lower under the leasing option. B. The ratio will be higher under the leasing option. C. The ratio will be the same regardless of the financing method selected. D. The ratio effects are unknown without the amount of the lease obligation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Long-term solvency ratios

85.

Which of these assets is generally considered to be the most liquid? A. Buildings B. Land C. Finished goods inventory D. Accounts receivable AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Liquidity

86.

High levels of liquidity may indicate: A. low levels of net working capital. B. low profit margins. C. high levels of economic value added. D. inefficient use of assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy

Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

87.

The current ratio is a good proxy for a firm's: A. liquidity. B. efficiency. C. degree of leverage. D. profitability. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Liquidity

88.

If a company uses cash to pay off some of its accounts payables, what effect will this have on its liquidity ratios, given that the ratios exceeded 1 before the payoff? A. The quick ratio and current ratio will both increase. B. The quick ratio and current ratio will both decrease. C. The quick ratio will increase but the current ratio will remain unchanged. D. The current ratio will increase but the quick ratio will remain unchanged. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

89.

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

90.

An asset turnover ratio of 1.75 can be interpreted as: A. $1.75 in sales are generated by every $1 of assets. B. $1.75 in additional assets are generated by every $1 of sales. C. $1.75 in assets are used to generate $1 of sales. D. $1 in sales are used to generate $1.75 in assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

91.

Which of these indicates that a firm is efficient? A. A high average collection period B. A high day's sales in inventories C. A low asset turnover D. A high inventory turnover AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Asset management ratios

92.

Calculate the average collection period for Dots Inc. if its accounts receivables were $550 at the beginning of a year in which the firm generated $3,000 of sales? A. 60 days B. 61 days C. 67 days D. 73 days Average collection period = $550 / ($3,000 / 365) = 67 days

93.

Which one of these ratios is commonly referred to as the acid-test ratio? A. Times interest earned ratio B. Quick ratio C. Cash coverage ratio D. Cash ratio AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. Topic: Short-term solvency ratios

94.

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

95.

What will be Gamma Inc.'s return on equity if total asset turnover is 0.85, operating profit margin is 0.15, two-thirds of its assets are financed through equity, and debt burden is 0.6? A. 9.56% B. 11.48% C. 16.96% D. 38.25% Leverage ratio = 1 / 0.67 ROE = leverage ratio × asset turnover × operating profit margin × debt burden ROE = 1.5 × 0.85 × 0.15 × 0.6 ROE = 0.1148, or 11.48%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: DuPont identity

96.

Which of the following is not a problem with EVA? A. EVA cannot be used to measure the profitability of a private company B. EVA cannot be used to compare the effectiveness of managers with different amounts of assets under their control C. EVA assumes that the book values of assets are equal to their current worth D. EVA assumes that you know the cost of capital AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Medium Gradable: automatic Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. Topic: Market value ratios

97.

In the past year, TVG had revenues of $3 million, cost of goods sold of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt outstanding with a face value of $1million, market value of $.92 million, and a coupon rate of 8%. What is the firm's times interest earned ratio? A. 3.75 B. 2.98 C. 2.80 D. 3.40 EBIT = revenues − COGS − depreciation EBIT = $3,000,000 − 2,500,000 − 200,000 EBIT = $300,000 Interest payments = 0.08 × $1,000,000 Interest payments = $80,000 Times interest earned = EBIT / interest payments Times interest earned = $300,000 / $80,000 Times interest earned = 3.75

Chapter 04 Test Bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Analyze

Blooms: Apply

Blooms: Evaluate

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 1 Medium

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 04-01 Calculate and interpret the market value and market value added of a public corporation.

Learning Objective: 04-02 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity.

Learning Objective: 04-03 Calculate and interpret key measures of operating efficiency, leverage, and liquidity.

Learning Objective: 04-04 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales.

Learning Objective: 04-05 Compare a company's financial standing with its competitors and its own position in previous years.

Topic: Asset management ratios

Topic: Collection Policy

Topic: Depreciation methods

Topic: DuPont identity

Topic: Income statement

Topic: Liquidity

Topic: Long-term solvency ratios

Topic: Market value ratios

Topic: Net working capital

Topic: Profitability ratios

Topic: Short-term solvency ratios

Chapter 05 Test Bank - Static Student: ___________________________________________________________________________

Compound interest pays interest for each time period on the original investment plus the accumulated interest. True

When money is invested at compound interest, the growth rate is the interest rate. True

False

With a fixed-rate mortgage, the proportion of each payment used to pay interest on the loan declines over time. True

False

An annuity factor represents the future value of $1 that is deposited today. True

False

A perpetuity is a special form of an annuity. True

False

The present value of an annuity due equals the present value of an ordinary annuity times the discount rate. True

False

Present values decline as the time to the cash flows increases. True

False

For a given amount, the lower the discount rate, the less the present value. True

False

Converting an annuity to an annuity due decreases the present value. True

False

10. It is important to discount both real and nominal cash flows at the real interest rate. True

False

11. The term "constant dollars" refers to equal payments for amortizing a loan. True

False

12. Nominal dollars refer to their purchasing power. True

False

13. When inflation is positive, the nominal interest rate is larger than the real rate. True

False

14. The effective annual interest rate cannot be less than the annual percentage rate. True

False

15. The more frequent the compounding, the higher the future value, other things equal. True

False

16. An annual percentage rate (APR) is determined by annualizing the rate using compound interest. True

False

17. A dollar tomorrow is worth more than a dollar today. True

False

18. To calculate present value, we discount the future value by some interest rate r, the discount rate. True

False

19. The discount factor is used to calculate the present value of $1 received in year t. True

False

20. You should never compare cash flows occurring at different times without first discounting them to a common date. True

False

21. Present values can always be calculated by dividing the cash flow by a discount factor. True

False

22. The five-year discount factor is less than the four-year discount factor. True

False

23. As long as the interest rate is positive, the future value will always be larger than the present value given any period of time. True

False

24. An annuity due must have a present value at least as large as an equivalent ordinary annuity. True

False

25. Any sequence of equally spaced, level cash flows is called an annuity. An annuity is also known as a perpetuity. True

False

26. A mortgage loan is an example of an amortizing loan. "Amortizing" means that part of the monthly payment is used to pay interest on the loan and part is used to reduce the amount of the loan. True

False

27. What is the future value of $10,000 on deposit for 2 years at 6% simple interest? A. $10,600 B. $11,236 C. $11,200 D. $13,382.26 28. If the five-year discount factor is d, what is the present value of $1 received in five years’ time? A. 1/(1 + d)5 B. 1/d. C. 5d. D. d. 29. How much interest is earned in just the third year on a $1,000 deposit that earns 7% interest compounded annually? A. $70.00 B. $80.14 C. $105.62 D. $140.00 30. How much interest will be earned in the next year on an investment paying 12% compounded annually if $100 was just credited to the account for interest? A. $88 B. $100 C. $112 D. $200 31. The concept of compound interest refers to: A. earning interest on the original investment. B. payment of interest on previously earned interest. C. investing for a multiyear period of time. D. determining the APR of the investment. 32. If interest is compounded semi-annually rather than annually, then: A. future values and present values will both be higher. B. futures values and present values will both be lower. C. future values will be lower and present values will be higher. D. Future values will be higher and present values will be lower.

33. Assume the total expense for your current year in college equals $20,000. How much would your parents have needed to invest 21 years ago in an account paying 8% compounded annually to cover this amount? A. $952.46 B. $1,600.00 C. $1,728.08 D. $3,973.11 34. An investment offers to pay $100 a year forever starting at the end of year 6. If the interest rate is 8%, what is the investment’s value today? A. $787.71 B. $850.73 C. $1,250 D. $1,586.87 35. An investment of $100 pays interest of 2.5% per quarter. What will be the value of this investment at the end of 3 years? A. $107.69 B. $133.10 C. $134.49 D. $313.84 36. A car’s price is currently $20,000 and is expected to rise by 4% a year. If the interest rate is 6%, how much do you need to put aside today to buy the car one year from now? A. $18,182 B. $19,231 C. $19,623 D. $4,080.08

37. If the 5-year discount factor is 0.7008, what is the interest rate? A. 5.43% B. 7.37% C. 8.00% D. 9.50% 38. Given the future value, which of the following will contribute to a lower present value? A. Higher discount rate B. Fewer time periods C. Less frequent discounting D. Lower discount factor 39. Cash flows occurring in different periods should not be compared unless: A. interest rates are expected to be stable. B. the flows occur no more than one year from each other. C. high rates of interest can be earned on the flows. D. the flows have been discounted to a common date.

40. What will be the approximate population of the United States, if its current population of 300 million grows at a compound rate of 2% annually for 25 years? A. 413 million B. 430 million C. 488 million D. 492 million 41. If the future value of an annuity due is $25,000 and $24,000 is the future value of an ordinary annuity that is otherwise similar to the annuity due, what is the implied discount rate? A. 1.04% B. 4.17% C. 5.00% D. 8.19% 42. A furniture store is offering free credit on purchases over $1,000. You observe that a big-screen television can be purchased for nothing down and $4,000 due in one year. The store next door offers an identical television for $3,650 but does not offer credit terms. Which statement below best describes the cost of the "free" credit? A. 8.75% B. 9.13% C. 9.59% D. 0% 43. How much must be invested today in order to generate a 5-year annuity of $1,000 per year, with the first payment 1 year from today, at an interest rate of 12%? A. $3,604.78 B. $3,746.25 C. $4,037.35 D. $4,604.78 44. The salesperson offers, "Buy this new car for $25,000 cash or, with an appropriate down payment, pay $500 per month for 48 months at 8% interest." Assuming that the salesperson does not offer a free lunch, calculate the "appropriate" down payment. A. $1,000.00 B. $4,519.04 C. $5,127.24 D. $8,000.00 45. What is the present value of the following payment stream, discounted at 8% annually: $1,000 at the end of year 1, $2,000 at the end of year 2, and $3,000 at the end of year 3? A. $5,022.10 B. $5,144.03 C. $5,423.87 D. $5,520.00

46. You invested $1,200 three years ago. During the three years, you earned annual rates of return of 4.8%, 9.2%, and 11.6%. What is the value of this investment today? A. $1,498.08 B. $1,512.11 C. $1,532.60 D. $1,549.19 47. You will be receiving cash flows of: $1,000 today, $2,000 at end of year 1, $4,000 at end of year 3, and $6,000 at end of year 5. What is the present value of these cash flows at an interest rate of 7%? A. $9,731.13 B. $10,412.27 C. $10,524.08 D. $11,524.91 48. Someone offers to buy your car for four, equal annual payments, beginning 2 years from today. If you think that the present value of your car is $9,000 and the interest rate is 10%, what is the minimum annual payment that you would accept? A. $2,839.24 B. $3,435.48 C. $3,123.16 D. $2,250 49. How much more is a perpetuity of $1,000 worth than an annuity of the same amount for 20 years? Assume an interest rate of 10% and cash flows at the end of each period. A. $297.29 B. $1,486.44 C. $1,635.08 D. $2,000.00 50. A stream of equal cash payments lasting forever is termed: A. an annuity. B. an annuity due. C. an installment plan. D. a perpetuity. 51. If the interest rate is 6%, which of these investments would you prefer? A. A single payment of $500 in year 3. B. A payment of $40 a year for 20 years starting in one year’s time. C. A perpetuity of $30 a year starting in one year’s time. D. A payment of $342.17 today 52. The present value of a perpetuity can be determined by: A. multiplying the payment by the interest rate. B. dividing the interest rate by the payment. C. multiplying the payment by the number of payments to be made. D. dividing the payment by the interest rate.

53. A perpetuity of $5,000 per year beginning today offers a 15% return. What is its present value? A. $33,333.33 B. $37,681.16 C. $38,333.33 D. $65,217.39 54. A bond promises to pay $1,000 20 years from today. No interest will be paid on the bonds during the 20 years If the interest rate is 7%, what is the bond’s present value? A. $50 B. $258.42 C. $629.56 D. $1,000 55. Your car loan requires payments of $200 per month for the first year and payments of $400 per month during the second year. The APR is 12% and payments begin in one month. What is the present value of this 2-year loan? A. $6,246.34 B. $6,389.78 C. $6,428.57 D. $6,753.05 56. Which one of the following will increase the present value of an annuity, other things equal? A. Increasing the interest rate B. Decreasing the interest rate C. Decreasing the number of payments D. Decreasing the amount of the payment 57. What is the present value of a five-period annuity of $3,000 if the interest rate per period is 12% and the first payment is made today? A. $9,655.65 B. $10,814.33 C. $12,112.05 D. $13,200.00 58. The sum of $3,000 is deposited into an account paying 10% annually. If $1,206 is withdrawn at the end of years 1 and 2, how much then remains in the account?" A. $1,326.97 B. $1,206.34 C. $1,097.40 D. $587.32

59. Suppose you take out a 30-year mortgage for $100,000 with annual payments. The interest rate on the mortgage is 8%. When you have paid off half the mortgage, so that the value of the remaining payments is reduced to $50,000, how many more payments need to be made? A. Approximately 15 payments B. Approximately 12 payments C. Approximately 8 payments D. Approximately 20 payments 60. What is the present value of a four-year annuity of $100 per year that makes its first payment 2 years from today if the discount rate is 9%? A. $297.22 B. $323.97 C. $356.85 D. $272.68 61. If $120,000 is borrowed for a home mortgage, to be repaid at 9% interest over 30 years with annual payments of $11,680.36, how much interest (as opposed to return of capital) is paid in the last year of the loan? A. $120,000 B. $162,000 C. $181,458 D. $227,598 62. $50,000 is borrowed, to be repaid in three equal, annual payments with 10% interest. Approximately how much principal is amortized with the first payment? A. $2,010.60 B. $5,000.00 C. $15,105.74 D. $20,105.74 63. An amortizing loan is one in which: A. the principal remains unchanged with each payment. B. accrued interest is paid regularly. C. the maturity of the loan is variable. D. the principal balance is reduced with each payment. 64. You're ready to make the last of four equal, annual payments on a $1,000 loan with a 10% interest rate. If the amount of the payment is $315.47, how much of that payment is accrued interest? A. $28.68 B. $31.55 C. $100.00 D. $315.47

65. What will be the monthly payment on a $75,000 30-year home mortgage at 1% interest per month? A. $771.46 B. $775.90 C. $1,028.61 D. $1,034.53 66. Your real estate agent mentions that homes in your price range require a payment of $1,200 per month for 30 years at 0.75% interest per month. What is the size of the mortgage with these terms? A. $128,035.05 B. $147,940.29 C. $149,138.24 D. $393,120.03 67. Assume you are making $989 monthly payments on your amortized mortgage. The amount of each payment that is applied to the principal balance: A. decreases with each succeeding payment. B. increases with each succeeding payment. C. is constant throughout the loan term. D. fluctuates monthly with changes in market interest rates. 68. How much must be saved at the end of each year for the next 10 years in order to accumulate $50,000, if you can earn 9% annually? Assume you contribute the same amount to your savings every year. A. $3,291.00 B. $3,587.87 C. $4,500.33 D. $4,587.79 69. Your retirement account has a current balance of $50,000. You plan to add $6,000 a year to the account for each of the next 30 years. Use a financial calculator or Excel to find what interest rate you need to earn in order to have $1,000,000 in the account at the end of the 30 years. ? A. 5.02% B. 7.24% C. 9.80% D. 10.07% 70. How much do you need when you retire to provide a $2,500 monthly check that will last for 25 years? Assume that your savings can earn 0.5% a month. A. $361,526.14 B. $388,017.16 C. $402,766.67 D. $414,008.24

71. The present value of an annuity stream of $100 per year is $614 when valued at a 10% rate. By approximately how much would the value change if these were annuities due? A. $10 B. $61.40 C. $10 ×Number of years in annuity stream D. $6.14 × Number of years in annuity stream 72. Approximately how much must be saved for retirement in order to withdraw $100,000 per year for the next 25 years if the balance earns 8% annually, and the first payment occurs one year from now? A. $1,067,477.62 B. $1,128,433.33 C. $1,487,320.09 D. $1,250,000.00 73. You have just retired with savings of $1.5 million. If you expect to live for 30 years and to earn 8% a year on your savings, how much can you afford to spend each year? Assume that you spend the money at the start of each year. A. $112,148.50 B. $120,000.00 C. $123,371.44 D. $133,241.15 74. How much can be accumulated for retirement if $2,000 is put aside at the end of each of the next 40 years? Assume that you can earn 9% a year on your savings. A. $87,200.00 B. $675,764.89 C. $736,583.73 D. $802,876.27 75. If inflation in Wonderland was 3% per month in 2016, what was the annual rate of inflation? A. 36.00% B. 42.58% C. 40.09% D. 41.27% 76. Assume your uncle recorded his salary history during a 40-year career and found that it had increased 10-fold. If inflation averaged 4% annually during the period, then over his career his purchasing power: A. remained on par with inflation. B. increased by nearly 1% annually. C. increased by nearly 2% annually. D. decreased.

77. Real interest rates: A. always exceed inflation rates. B. can decline to zero but no lower. C. can be negative, zero, or positive. D. traditionally exceed nominal rates. 78. On the day you retire you have $1,000,000 saved. You expect to live another 25 years during which time you expect to earn 6.19% on your savings while inflation averages 2.5% annually. Assume you want to spend the same amount each year in real terms and die on the day you spend your last dime. What real amount will you be able to spend each year? A. $61,334.36 B. $79,644.58 C. $79,211.09 D. $61,931.78 79. What is the expected real rate of interest for an account that offers a 12% nominal rate of return when the rate of inflation is 6% annually? A. 5.00% B. 5.66% C. 6.00% D. 9.46% 80. What happens over time to the real cost of purchasing a home if the mortgage payments are fixed in nominal terms and inflation is in existence? A. The real cost is constant. B. The real cost is increasing. C. The real cost is decreasing. D. The price index must be known to answer this question. 81. What is the minimum nominal rate of return that you should accept if you require a 4% real rate of return and the rate of inflation is expected to average 3.5% during the investment period? A. 7.36% B. 7.50% C. 7.64% D. 8.01% 82. What APR is being earned on a deposit of $5,000 made 10 years ago today if the deposit is worth $9,848.21 today? The deposit pays interest semiannually. A. 3.56% B. 6.76% C. 6.89% D. 7.12%

83. An interest rate that has been annualized using compound interest is termed the: A. discount factor. B. annual percentage rate. C. discounted interest rate. D. effective annual interest rate. 84. What is the effective annual rate of interest on a deposit that pays interest of 10% continuously compounded? A. 10.000% B. 10.517% C. 1.105% D. 9.531% 85. What is the relationship between an annually compounded rate and the annual percentage rate (APR) which is calculated for truth-in-lending laws for a loan requiring monthly payments? A. The APR is lower than the annually compounded rate. B. The APR is higher than the annually compounded rate. C. The APR equals the annually compounded rate. D. The answer depends on the interest rate. 86. What is the APR on a loan that charges interest at the rate of 1.4% per month? A. 10.20% B. 14.00% C. 16.80% D. 18.16% 87. If interest is paid m times per year, then the per-period interest rate equals the: A. effective annual rate divided by m. B. compound interest rate times m. C. effective annual rate. D. annual percentage rate (APR) divided by m. 88. If the effective annual rate of interest is known to be 16.08% on a debt that has quarterly payments, what is the annual percentage rate? A. 4.02% B. 10.02% C. 14.50% D. 15.19% 89. Would a depositor prefer an APR of 8% with monthly compounding or an APR of 8.5% with semiannual compounding? A. 8.0% with monthly compounding B. 8.5% with semiannual compounding C. The depositor would be indifferent. D. The time period must be known to select the preferred account.

90. What is the annually compounded rate of interest on an account with an APR of 10% and monthly compounding? A. 10.00% B. 10.47% C. 10.52% D. 11.05% 91. What is the APR on a loan with an effective annual rate of 15.26% and weekly compounding of interest? A. 14.35% B. 14.49% C. 13.97% D. 14.22% 92. What is the effective annual interest rate on a 9% APR automobile loan that has monthly payments? A. 9.00% B. 9.38% C. 9.81% D. 10.94% 93. Other things being equal, the more frequent the compounding period, the: A. higher the annual percentage rate. B. lower the annual percentage rate. C. higher the effective annual interest rate. D. lower the effective annual interest rate. 94. How much interest will be earned in an account into which $1,000 is deposited for one year with continuous compounding at a 13% rate? A. $130.00 B. $138.83 C. $169.00 D. $353.34 95. What is the present value of $100 to be deposited today into an account paying 8%, compounded semiannually for 2 years? A. $85.48 B. $100.00 C. $116.00 D. $116.99 96. If a borrower promises to pay you $1,900 nine years from now in return for a loan of $1,000 today, what effective annual interest rate is being offered if interest is compounded annually? A. 5.26% B. 7.39% C. 9.00% D. 10.00%

97. What is the present value of your trust fund if you have projected that it will provide you with $50,000 7 years from today and it earns 10% compounded annually? A. $25,000.00 B. $25,657.91 C. $28,223.70 D. $29,411.76 98. What is the discount factor for $1 to be received in 5 years at a discount rate of 8%? A. 0.4693 B. 0.5500 C. 0.6000 D. 0.6806 99. How much more would you be willing to pay today for an investment offering $10,000 in 4 years rather than in 5 years? Your discount rate is 8%. A. $544.47 B. $681.48 C. $740.74 D. $800.00 100. "Give me $5,000 today and I'll return $10,000 to you in 5 years," offers the investment broker. To the nearest percent, what annual interest rate is being offered? A. 12.29% B. 13.67% C. 14.87% D. 12.84% 101. The APR on a loan must be equal to the effective annual rate when: A. compounding occurs monthly. B. compounding occurs annually. C. the loan is for less than one year. D. the loan is for more than one year. 102. A car dealer offers payments of $522.59 per month for 48 months on a $25,000 car after making a $4,000 down payment. What is the loan's APR? A. 6% B. 9% C. 11% D. 12%

103. A credit card account that charges interest at the rate of 1.25% per month would have an annually compounded rate of _____ and an APR of ____. A. 16.08%; 15.00% B. 14.55%; 16.08% C. 12.68%; 15.00% D. 15.00%; 14.55% 104. Eighteen years from now, 4 years of college are expected to cost $150,000. How much more must be deposited into an account today to fund this expense if you can earn only 8% on your savings rather than the 11% you hope to earn? A. $12,211.18 B. $13,609.21 C. $14,006.41 D. $14,614.03 105. Prizes are often not "worth" as much as claimed. What is the value of a prize of $5,000,000 that is to be received in 20 equal yearly payments, with the first payment beginning today? Assume an interest rate of 7%. A. $2,833,898.81 B. $2,911,015.68 C. $2,609,144.14 D. $2,738,304.13 106. A loan officer states, "Thousands of dollars can be saved by switching to a 15-year mortgage from a 30-year mortgage." Calculate the difference in payments on a 30-year mortgage at an interest rate of .75% a month versus a 15-year mortgage with an interest rate of .7% a month. Both mortgages are for $100,000 and have monthly payments. What is the difference in total dollars that will be paid to the lender under each loan? (Round the monthly payment amounts to 2 decimal places.) A. $89,211 B. $98,406 C. $113,465 D. $124,300 107. Would you prefer a savings account that paid 7% interest compounded quarterly, 6.8% compounded monthly, 7.2% compounded weekly, or an account that paid 7.5% with annual compounding? A. 7% compounded quarterly B. 6.8% compounded monthly C. 7.2% compounded weekly D. 7.5% compounded annually 108. After reading the fine print in your credit card agreement, you find that the "low" interest rate is actually an 18% APR, or 1.5% per month. What is the effective annual rate? A. 18.47% B. 19.56% C. 18.82% D. 19.41%

109. You are considering the purchase of a home that would require a mortgage of $150,000. How much more in total interest will you pay if you select a 30-year mortgage at 5.65% rather than a 15-year mortgage at 4.9%? (Round the monthly payment amount to 2 decimal places.) A. $86,311.18 B. $78,487.92 C. $99,595.80 D. $102,486.68 110. Lester's just signed a contract that will provide the firm with annual cash inflows of $28,000, $35,000, and $42,000 over the next three years with the first payment of $28,000 occurring one year from today. What is this contract worth today at a discount rate of 7.25%? A. $88,311.08 B. $89,423.91 C. $90,580.55 D. $91,341.41 111. Miller's Hardware plans on saving $42,000, $54,000, and $58,000 at the end of each year for the next three years, respectively. How much will the firm have saved at the end of the three years if it can earn 4.5% on its savings? A. $160,295.05 B. $158,098.15 C. $167,508.33 D. $165,212.57

Chapter 05 Test Bank - Static Key 1.

Compound interest pays interest for each time period on the original investment plus the accumulated interest. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Simple and compound interest

When money is invested at compound interest, the growth rate is the interest rate. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Simple and compound interest

For a given amount, the lower the discount rate, the less the present value. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

Present values decline as the time to the cash flows increases. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-multiple cash flows

The present value of an annuity due equals the present value of an ordinary annuity times the discount rate. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy

Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Annuities

A perpetuity is a special form of an annuity. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Perpetuities

An annuity factor represents the future value of $1 that is deposited today. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Annuities

With a fixed-rate mortgage, the proportion of each payment used to pay interest on the loan declines over time. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Amortization

Converting an annuity to an annuity due decreases the present value. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Annuities

10.

It is important to discount both real and nominal cash flows at the real interest rate. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Nominal and real rates

11.

The term "constant dollars" refers to equal payments for amortizing a loan. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Present value-multiple cash flows

12.

Nominal dollars refer to their purchasing power. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Nominal and real rates

13.

When inflation is positive, the nominal interest rate is larger than the real rate. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Nominal and real rates

14.

The effective annual interest rate cannot be less than the annual percentage rate. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Simple and compound interest

15.

The more frequent the compounding, the higher the future value, other things equal. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Future value-single cash flow

16.

An annual percentage rate (APR) is determined by annualizing the rate using compound interest. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Simple and compound interest

17.

A dollar tomorrow is worth more than a dollar today. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Future value-single cash flow

18.

To calculate present value, we discount the future value by some interest rate r, the discount rate. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

19.

The discount factor is used to calculate the present value of $1 received in year t. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

20.

You should never compare cash flows occurring at different times without first discounting them to a common date. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-multiple cash flows

21.

Present values can always be calculated by dividing the cash flow by a discount factor. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Present value-single cash flow

22.

The five-year discount factor is less than the four-year discount factor. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

23.

As long as the interest rate is positive, the future value will always be larger than the present value given any period of time. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Future value-single cash flow

24.

An annuity due must have a present value at least as large as an equivalent ordinary annuity. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Annuities

25.

Any sequence of equally spaced, level cash flows is called an annuity. An annuity is also known as a perpetuity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Perpetuities

26.

A mortgage loan is an example of an amortizing loan. "Amortizing" means that part of the monthly payment is used to pay interest on the loan and part is used to reduce the amount of the loan. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Amortization

27.

What is the future value of $10,000 on deposit for 2 years at 6% simple interest? A. $10,600 B. $11,236 C. $11,200 D. $13,382.26 FV = $10,000 + 2 × 0.06 × 10,000= $11,200

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Simple and compound interest

28.

If the five-year discount factor is d, what is the present value of $1 received in five years’ time? A. 1/(1 + d)5 B. 1/d. C. 5d. D. d. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

29.

How much interest is earned in just the third year on a $1,000 deposit that earns 7% interest compounded annually? A. $70.00 B. $80.14 C. $105.62 D. $140.00 $1000.00 × (1.07)2 = $1,144.90 after 2 years $1,144.90 × 0.07 = $80.14

30.

How much interest will be earned in the next year on an investment paying 12% compounded annually if $100 was just credited to the account for interest? A. $88 B. $100 C. $112 D. $200 The investment will again pay $100 plus interest on the previous interest: $100 × 1.12 = $112

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Simple and compound interest

31.

The concept of compound interest refers to: A. earning interest on the original investment. B. payment of interest on previously earned interest. C. investing for a multiyear period of time. D. determining the APR of the investment. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic

Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate. Topic: Simple and compound interest

32.

If interest is compounded semi-annually rather than annually, then: A. future values and present values will both be higher. B. futures values and present values will both be lower. C. future values will be lower and present values will be higher. D. Future values will be higher and present values will be lower. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Simple and compound interest

33.

Assume the total expense for your current year in college equals $20,000. How much would your parents have needed to invest 21 years ago in an account paying 8% compounded annually to cover this amount? A. $952.46 B. $1,600.00 C. $1,728.08 D. $3,973.11 PV = $20,000 / (1.08)21 PV = $3,973.11

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

34.

An investment offers to pay $100 a year forever starting at the end of year 6. If the interest rate is 8%, what is the investment’s value today? A. $787.71 B. $850.73 C. $1,250 D. $1,586.87 It will be worth 100 / 0.08 = $1,250 at the end of year 5, and therefore worth $1,250 / 1.0865 = $850.73 today.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment.

Topic: Perpetuities

35.

An investment of $100 pays interest of 2.5% per quarter. What will be the value of this investment at the end of 3 years? A. $107.69 B. $133.10 C. $134.49 D. $313.84 FV = PV(1 + r)t =100 × 1.02512 = $134.49

36.

A car’s price is currently $20,000 and is expected to rise by 4% a year. If the interest rate is 6%, how much do you need to put aside today to buy the car one year from now?

A. $18,182 B. $19,231 C. $19,623 D. $4,080.08 Future price of car = ($20,000 × 1.04) = $20,800 PV = $ 20,800 / (1.06) = $19,623

37.

If the 5-year discount factor is 0.7008, what is the interest rate? A. 5.43% B. 7.37% C. 8.00% D. 9.50% FV = PV(1 + r)t 0.7008 = 1/(1 + r)5 r = 0.0737, or 7.37%

38.

Given the future value, which of the following will contribute to a lower present value? A. Higher discount rate B. Fewer time periods C. Less frequent discounting D. Lower discount factor AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

39.

Cash flows occurring in different periods should not be compared unless: A. interest rates are expected to be stable. B. the flows occur no more than one year from each other. C. high rates of interest can be earned on the flows. D. the flows have been discounted to a common date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-multiple cash flows

40.

What will be the approximate population of the United States, if its current population of 300 million grows at a compound rate of 2% annually for 25 years? A. 413 million B. 430 million C. 488 million D. 492 million FV = PV(1 + r)t FV = 300 million × (1.02)25 FV = 492.2 million ≈ 492 million

41.

If the future value of an annuity due is $25,000 and $24,000 is the future value of an ordinary annuity that is otherwise similar to the annuity due, what is the implied discount rate? A. 1.04% B. 4.17% C. 5.00% D. 8.19% FVAD = FVOA × (1 + r) $25,000 = $24,000 × (1 + r) r = 0.0417, or 4.17%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Annuities

42.

A furniture store is offering free credit on purchases over $1,000. You observe that a big-screen television can be purchased for nothing down and $4,000 due in one year. The store next door offers an identical television for $3,650 but does not offer credit terms. Which statement below best describes the cost of the "free" credit? A. 8.75% B. 9.13% C. 9.59% D. 0% FV = PV(1 + r)t $4,000 = $3,650(1 + r) r = 0.0959, or 9.59%

43.

How much must be invested today in order to generate a 5-year annuity of $1,000 per year, with the first payment 1 year from today, at an interest rate of 12%? A. $3,604.78 B. $3,746.25 C. $4,037.35 D. $4,604.78 PV = $1,000{(1 / 0.12) − [1 / 0.12(1.12 5)]} PV = $3,604.78

44.

The salesperson offers, "Buy this new car for $25,000 cash or, with an appropriate down payment, pay $500 per month for 48 months at 8% interest." Assuming that the salesperson does not offer a free lunch, calculate the "appropriate" down payment. A. $1,000.00 B. $4,519.04 C. $5,127.24 D. $8,000.00 PV = $500 × {[1 / (0.08 / 12)] − [1/(0.08 / 12)(1 + (0.08 / 12) 48)]} PV = $20,480.96 Down payment = $25,000 − 20,480.96 = $4,519.04

45.

What is the present value of the following payment stream, discounted at 8% annually: $1,000 at the end of year 1, $2,000 at the end of year 2, and $3,000 at the end of year 3? A. $5,022.10 B. $5,144.03 C. $5,423.87 D. $5,520.00 PV = $1,000 / 1.08 + $2,000 / 1.082 + $3,000 / 1.083 PV = $5,022.10

46.

You invested $1,200 three years ago. During the three years, you earned annual rates of return of 4.8%, 9.2%, and 11.6%. What is the value of this investment today? A. $1,498.08 B. $1,512.11 C. $1,532.60 D. $1,549.19 FV = PV(1 + r)t FV = PV(1 + r)t (1 + r)t (1 + r)t FV = $1,200(1.048)1 (1.092)1 (1.116)1 FV = $1,532.60

47.

You will be receiving cash flows of: $1,000 today, $2,000 at end of year 1, $4,000 at end of year 3, and $6,000 at end of year 5. What is the present value of these cash flows at an interest rate of 7%? A. $9,731.13 B. $10,412.27 C. $10,524.08 D. $11,524.91 PV = FV / (1 + r)t PV = $1,000 + $2,000 / 1.071 + $4,000 / 1.073 + $6,000 / 1.075 PV = $10,412.27

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-multiple cash flows

48.

Someone offers to buy your car for four, equal annual payments, beginning 2 years from today. If you think that the present value of your car is $9,000 and the interest rate is 10%, what is the minimum annual payment that you would accept? A. $2,839.24 B. $3,435.48 C. $3,123.16 D. $2,250 PV = C{(1 / 0.1) − [1 / (0.1 × 1.14)]} / 1.1 = $9,000 C = $3,123.16

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Annuities

49.

How much more is a perpetuity of $1,000 worth than an annuity of the same amount for 20 years? Assume an interest rate of 10% and cash flows at the end of each period. A. $297.29 B. $1,486.44 C. $1,635.08 D. $2,000.00 PVPerpetuity = $1,000 / 0.10 = $10,000 PVAnnuity = $1,000[1 / 0.10 − 1 / 0.10(1.10)20] PVAnnuity = $8,513.56 Difference = $10,000 − 8,513.56 = $1,486.44

50.

A stream of equal cash payments lasting forever is termed: A. an annuity. B. an annuity due. C. an installment plan. D. a perpetuity. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Perpetuities

51.

If the interest rate is 6%, which of these investments would you prefer? A. A single payment of $500 in year 3. B. A payment of $40 a year for 20 years starting in one year’s time. C. A perpetuity of $30 a year starting in one year’s time. D. A payment of $342.17 today PV($500 in year 3) = 500 / 1.063 = $419.81 PV ($40 a year for 20 years) = 40(1 / 0.06 − 1 / (0.06 × 1.0620)) = $458.80 PV ($30 in perpetuity) = 30 / 0.06 = $500

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Present value-multiple cash flows

52.

The present value of a perpetuity can be determined by: A. multiplying the payment by the interest rate. B. dividing the interest rate by the payment. C. multiplying the payment by the number of payments to be made. D. dividing the payment by the interest rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Perpetuities

53.

A perpetuity of $5,000 per year beginning today offers a 15% return. What is its present value? A. $33,333.33 B. $37,681.16 C. $38,333.33 D. $65,217.39 PV = $5,000 + $5,000 / r PV = $5,000 + $5,000 / 0.15 PV = $5,000 + $5,000 / 0.15 PV = $38,333.33

54.

A bond promises to pay $1,000 20 years from today. No interest will be paid on the bonds during the 20 years If the interest rate is 7%, what is the bond’s present value? A. $50 B. $258.42 C. $629.56 D. $1,000 PV = FV / (1 + r)t =$1,000 / 1.0720 = $258.42

55.

Your car loan requires payments of $200 per month for the first year and payments of $400 per month during the second year. The APR is 12% and payments begin in one month. What is the present value of this 2-year loan? A. $6,246.34 B. $6,389.78 C. $6,428.57 D. $6,753.05 PV = {$200 {(1 / 0.01) − [1 / 0.01(1.01) 12]}} + ({$400 {(1 / 0.01) − [1 / 0.01(1.01)12]} / 1.0112)} PV = $6,246.34

56.

Which one of the following will increase the present value of an annuity, other things equal? A. Increasing the interest rate B. Decreasing the interest rate C. Decreasing the number of payments D. Decreasing the amount of the payment AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-annuity

57.

What is the present value of a five-period annuity of $3,000 if the interest rate per period is 12% and the first payment is made today? A. $9,655.65 B. $10,814.33 C. $12,112.05 D. $13,200.00 PVAD = PVOA × (1 + r) PVAD = {$3,000[1 / 0.12 − 1 / 0.12(1.12)5]} × 1.12 PVAD = $12,112.05

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-annuity

58.

The sum of $3,000 is deposited into an account paying 10% annually. If $1,206 is withdrawn at the end of years 1 and 2, how much then remains in the account?" A. $1,326.97 B. $1,206.34 C. $1,097.40 D. $587.32 FVYear 1 = PV(1 + r) − Withdrawal FVYear 1 = $3,000(1.1) − $1,206 FVYear 1 = $2,094 FVYear 2 = FVYear 1 (1 + r) − Withdrawal FVYear 2 = $2,094(1.1) − $1,206FVYear 2 = $1,097.40

59.

Suppose you take out a 30-year mortgage for $100,000 with annual payments. The interest rate on the mortgage is 8%. When you have paid off half the mortgage, so that the value of the remaining payments is reduced to $50,000, how many more payments need to be made? A. Approximately 15 payments B. Approximately 12 payments C. Approximately 8 payments D. Approximately 20 payments Solve first for the annual payment: $100,000 = PMT(1 / 0.08 − 0.08 × 1.08 30). PMT = $8,882.74 PV = PMT [(1 / r) − 1 / r(1 + r)t] $50,000 = 8,882.74{1 / 0.08−1 / (0.08 × 1.08t} Either use logs or trial and error to find t ≈ 8

60.

What is the present value of a four-year annuity of $100 per year that makes its first payment 2 years from today if the discount rate is 9%? A. $297.22 B. $323.97 C. $356.85 D. $272.68 PV = {$100[(1 / 0.09) − 1 / 0.09(1.09)4]} / 1.09 PV = $297.22

61.

If $120,000 is borrowed for a home mortgage, to be repaid at 9% interest over 30 years with annual payments of $11,680.36, how much interest (as opposed to return of capital) is paid in the last year of the loan? A. $120,000 B. $162,000 C. $181,458 D. $227,598 Value of loan at start of last year = $11,680.36 / 1.09 = $10,715.93 Interest on loan in last year = 0.09 × $10,715.93 = $964.43

62.

$50,000 is borrowed, to be repaid in three equal, annual payments with 10% interest. Approximately how much principal is amortized with the first payment? A. $2,010.60 B. $5,000.00 C. $15,105.74 D. $20,105.74 Payment = $50,000 / [1 / 0.1 − 1 / 0.1(1.1) 3] Payment = $20,105.74 Principal payment = $20,105.74 − ($50,000 × 0.1) Principal payment = $15,105.74

63.

An amortizing loan is one in which: A. the principal remains unchanged with each payment. B. accrued interest is paid regularly. C. the maturity of the loan is variable. D. the principal balance is reduced with each payment. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Amortization

64.

You're ready to make the last of four equal, annual payments on a $1,000 loan with a 10% interest rate. If the amount of the payment is $315.47, how much of that payment is accrued interest? A. $28.68 B. $31.55 C. $100.00 D. $315.47 $315.47 − ($315.47 / 1.1) = $28.68

65.

What will be the monthly payment on a $75,000 30-year home mortgage at 1% interest per month? A. $771.46 B. $775.90 C. $1,028.61 D. $1,034.53 Payment = $75,000 / [(1 / 0.01) − 1 / 0.01(1.01)360] Payment = $771.46

66.

Your real estate agent mentions that homes in your price range require a payment of $1,200 per month for 30 years at 0.75% interest per month. What is the size of the mortgage with these terms? A. $128,035.05 B. $147,940.29 C. $149,138.24 D. $393,120.03 PV = $1,200[(1 / 0.0075) − 1 / 0.0075(1.0075)360] PV = $149,138.24

67.

Assume you are making $989 monthly payments on your amortized mortgage. The amount of each payment that is applied to the principal balance: A. decreases with each succeeding payment. B. increases with each succeeding payment. C. is constant throughout the loan term. D. fluctuates monthly with changes in market interest rates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Amortization

68.

How much must be saved at the end of each year for the next 10 years in order to accumulate $50,000, if you can earn 9% annually? Assume you contribute the same amount to your savings every year. A. $3,291.00 B. $3,587.87 C. $4,500.33 D. $4,587.79 Payment = $50,000 / [(1.0910 − 1) / 0.09] Payment = $3,291.00

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments. Topic: Annuities

69.

Your retirement account has a current balance of $50,000. You plan to add $6,000 a year to the account for each of the next 30 years. Use a financial calculator or Excel to find what interest rate you need to earn in order to have $1,000,000 in the account at the end of the 30 years. ? A. 5.02% B. 7.24% C. 9.80% D. 10.07% Financial calculator: n = 30; PV = −50,000; PMT = −6,000; FV = 1,000,000; CPT i = 7.24%, or Excel function Rate(nper, PMT, PV, FV)

70.

How much do you need when you retire to provide a $2,500 monthly check that will last for 25 years? Assume that your savings can earn 0.5% a month. A. $361,526.14 B. $388,017.16 C. $402,766.67 D. $414,008.24 Monthly interest rate = 0.06 / 12 = 0.005 PV = $2,500 {(1 / 0.005) − [1 / 0.005(1.005)12 × 25]} PV = $388,017.16

71.

The present value of an annuity stream of $100 per year is $614 when valued at a 10% rate. By approximately how much would the value change if these were annuities due? A. $10 B. $61.40 C. $10 ×Number of years in annuity stream D. $6.14 × Number of years in annuity stream PVAnnuity due = PV ordinary annuity × (1 + r) Difference = $614(1.1) − $614 = $61.40

72.

Approximately how much must be saved for retirement in order to withdraw $100,000 per year for the next 25 years if the balance earns 8% annually, and the first payment occurs one year from now? A. $1,067,477.62 B. $1,128,433.33 C. $1,487,320.09 D. $1,250,000.00 PV = $100,000 {(1 / 0.08) − [1 / 0.08(1.08)25]} PV = $1,067,477.62

73.

You have just retired with savings of $1.5 million. If you expect to live for 30 years and to earn 8% a year on your savings, how much can you afford to spend each year? Assume that you spend the money at the start of each year. A. $112,148.50 B. $120,000.00 C. $123,371.44 D. $133,241.15 $1,500,000 = PmtOA {(1 / 0.08) − [1 / 0.08(1.08)30]} PMTOA = $133,241.15 PMTAD = PMTOA / (1 + r) PMTAD = $133,241.15 / 1.08 PMTAD = $123,371.44

74.

How much can be accumulated for retirement if $2,000 is put aside at the end of each of the next 40 years? Assume that you can earn 9% a year on your savings. A. $87,200.00 B. $675,764.89 C. $736,583.73 D. $802,876.27 FV = $2,000 {[(1 + 0.09)40 − 1] / 0.09} FV = $675,764.89

75.

If inflation in Wonderland was 3% per month in 2016, what was the annual rate of inflation? A. 36.00% B. 42.58% C. 40.09% D. 41.27% (1.03)12 − 1 = 0.4258, or 42.58%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Simple and compound interest

76.

Assume your uncle recorded his salary history during a 40-year career and found that it had increased 10-fold. If inflation averaged 4% annually during the period, then over his career his purchasing power: A. remained on par with inflation. B. increased by nearly 1% annually. C. increased by nearly 2% annually. D. decreased. FV = PV(1 + r)t 10 = 1(1 + i)40 r = 5.93% Real rate = (1.0593 / 1.04) − 1 = 0.0186, or 1.86%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Nominal and real rates

77.

Real interest rates: A. always exceed inflation rates. B. can decline to zero but no lower. C. can be negative, zero, or positive. D. traditionally exceed nominal rates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Nominal and real rates

78.

On the day you retire you have $1,000,000 saved. You expect to live another 25 years during which time you expect to earn 6.19% on your savings while inflation averages 2.5% annually. Assume you want to spend the same amount each year in real terms and die on the day you spend your last dime. What real amount will you be able to spend each year? A. $61,334.36 B. $79,644.58 C. $79,211.09 D. $61,931.78 Real rate = (1.0619 / 1.025) − 1 = 0.036 $1,000,000 = PMT {(1 / 0.036) − [1 / 0.036(1.036) 25]} PMT = $61,334.36

79.

What is the expected real rate of interest for an account that offers a 12% nominal rate of return when the rate of inflation is 6% annually? A. 5.00% B. 5.66% C. 6.00% D. 9.46% 1 + real interest rate = (1 + nominal interest rate) / (1 + inflation) 1 + real interest rate = 1.12 / 1.06 Real interest rate = 5.66%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Nominal and real rates

80.

What happens over time to the real cost of purchasing a home if the mortgage payments are fixed in nominal terms and inflation is in existence? A. The real cost is constant. B. The real cost is increasing. C. The real cost is decreasing. D. The price index must be known to answer this question. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates. Topic: Nominal and real rates

81.

What is the minimum nominal rate of return that you should accept if you require a 4% real rate of return and the rate of inflation is expected to average 3.5% during the investment period? A. 7.36% B. 7.50% C. 7.64% D. 8.01% 1 + nominal rate = (1 + real rate)(1 + inflation rate) Nominal rate = (1.04 × 1.035) − 1 Nominal rate = 7.64%

82.

What APR is being earned on a deposit of $5,000 made 10 years ago today if the deposit is worth $9,848.21 today? The deposit pays interest semiannually. A. 3.56% B. 6.76% C. 6.89% D. 7.12% FV = PV (1 + r)t $9,848.21 = $5,000 [1 + (r / 2)]10 × 2 r = 6.89%

83.

An interest rate that has been annualized using compound interest is termed the: A. discount factor. B. annual percentage rate. C. discounted interest rate. D. effective annual interest rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

84.

What is the effective annual rate of interest on a deposit that pays interest of 10% continuously compounded? A. 10.000% B. 10.517% C. 1.105% D. 9.531% Effective interest rate = e0.1 − 1 = 0.10517, or 10.517%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

85.

What is the relationship between an annually compounded rate and the annual percentage rate (APR) which is calculated for truth-in-lending laws for a loan requiring monthly payments? A. The APR is lower than the annually compounded rate. B. The APR is higher than the annually compounded rate. C. The APR equals the annually compounded rate. D. The answer depends on the interest rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

86.

What is the APR on a loan that charges interest at the rate of 1.4% per month? A. 10.20% B. 14.00% C. 16.80% D. 18.16% APR = 1.4% × 12 = 16.80%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

87.

If interest is paid m times per year, then the per-period interest rate equals the: A. effective annual rate divided by m. B. compound interest rate times m. C. effective annual rate. D. annual percentage rate (APR) divided by m. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

88.

If the effective annual rate of interest is known to be 16.08% on a debt that has quarterly payments, what is the annual percentage rate? A. 4.02% B. 10.02% C. 14.50% D. 15.19% APR = [(1.1608)0.25 − 1] × 4 APR = 0.1519, or 15.19%

89.

Would a depositor prefer an APR of 8% with monthly compounding or an APR of 8.5% with semiannual compounding? A. 8.0% with monthly compounding B. 8.5% with semiannual compounding C. The depositor would be indifferent. D. The time period must be known to select the preferred account. EAR = [1 + (0.08 / 12)]12 − 1 = 8.30% EAR = [1 + (0.085 / 2)]2 − 1 = 8.68% The depositor will prefer the option with the higher EAR (effective annual rate).

90.

What is the annually compounded rate of interest on an account with an APR of 10% and monthly compounding? A. 10.00% B. 10.47% C. 10.52% D. 11.05% EAR = [1 + (0.10 / 12)] 12 − 1 = 0.1047, or 10.47%

91.

What is the APR on a loan with an effective annual rate of 15.26% and weekly compounding of interest? A. 14.35% B. 14.49% C. 13.97% D. 14.22% APR = [(1.1526)1 / 52 − 1] × 52 = 0.1422, or 14.22%

92.

What is the effective annual interest rate on a 9% APR automobile loan that has monthly payments? A. 9.00% B. 9.38% C. 9.81% D. 10.94% EAR = [1 + (0.09 / 12)]12 − 1 = 0.0938, or 9.38%

93.

Other things being equal, the more frequent the compounding period, the: A. higher the annual percentage rate. B. lower the annual percentage rate. C. higher the effective annual interest rate. D. lower the effective annual interest rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

94.

How much interest will be earned in an account into which $1,000 is deposited for one year with continuous compounding at a 13% rate? A. $130.00 B. $138.83 C. $169.00 D. $353.34 Interest = $1,000(e0.13) − $1,000 = $138.83

95.

What is the present value of $100 to be deposited today into an account paying 8%, compounded semiannually for 2 years? A. $85.48 B. $100.00 C. $116.00 D. $116.99 AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-02 Calculate the present value of a future payment. Topic: Present value-single cash flow

96.

If a borrower promises to pay you $1,900 nine years from now in return for a loan of $1,000 today, what effective annual interest rate is being offered if interest is compounded annually? A. 5.26% B. 7.39% C. 9.00% D. 10.00% FV = PV × (1 + r)t $1,900 = $1,000 × (1 + r)9 r = 1.91 / 9 − 1 r = 0.0739, or 7.39%

97.

What is the present value of your trust fund if you have projected that it will provide you with $50,000 7 years from today and it earns 10% compounded annually? A. $25,000.00 B. $25,657.91 C. $28,223.70 D. $29,411.76 PV = FV / (1 + r)t PV = $50,000 / 1.107 PV = $25,657.91

98.

What is the discount factor for $1 to be received in 5 years at a discount rate of 8%? A. 0.4693 B. 0.5500 C. 0.6000 D. 0.6806 PV = FV / (1 + r)t PV = 1 / 1.085 PV = 0.6806

99.

How much more would you be willing to pay today for an investment offering $10,000 in 4 years rather than in 5 years? Your discount rate is 8%. A. $544.47 B. $681.48 C. $740.74 D. $800.00 Difference = FV / (1 + r)t −1 − FV / (1 + r) Difference = $10,000 / 1.084 − $10,000 / 1.085 Difference = $544.47

100.

"Give me $5,000 today and I'll return $10,000 to you in 5 years," offers the investment broker. To the nearest percent, what annual interest rate is being offered? A. 12.29% B. 13.67% C. 14.87% D. 12.84% FV = PV(1 + r)t $10,000 = $5,000(1 + r)5 r = 21 / 5 − 1 r = 0.1487, or 14.87%

101.

The APR on a loan must be equal to the effective annual rate when: A. compounding occurs monthly. B. compounding occurs annually. C. the loan is for less than one year. D. the loan is for more than one year. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

102.

A car dealer offers payments of $522.59 per month for 48 months on a $25,000 car after making a $4,000 down payment. What is the loan's APR? A. 6% B. 9% C. 11% D. 12% $25,000 − 4,000 = $522.59 {(1 / r) − [1 / r(1 + r)48]} Using a financial calculator or Excel, r = 0.0075 APR = 0.0075 × 12 APR = 0.09, or 9%

103.

A credit card account that charges interest at the rate of 1.25% per month would have an annually compounded rate of _____ and an APR of ____. A. 16.08%; 15.00% B. 14.55%; 16.08% C. 12.68%; 15.00% D. 15.00%; 14.55% EAR = (1 + 0.0125)12 − 1 = 0.1608, or 16.08% APR = 1.25% × 12 = 15.00%

104.

Eighteen years from now, 4 years of college are expected to cost $150,000. How much more must be deposited into an account today to fund this expense if you can earn only 8% on your savings rather than the 11% you hope to earn? A. $12,211.18 B. $13,609.21 C. $14,006.41 D. $14,614.03 Additional deposit = $150,000 / 1.0818 − $150,000 / 1.1118 Additional deposit = $14,614.03

105.

Prizes are often not "worth" as much as claimed. What is the value of a prize of $5,000,000 that is to be received in 20 equal yearly payments, with the first payment beginning today? Assume an interest rate of 7%. A. $2,833,898.81 B. $2,911,015.68 C. $2,609,144.14 D. $2,738,304.13 Annual payment = $5,000,000 / 20 = $250,000 PV = ($250,000 {(1 / 0.07) − [1 / 0.07(1.07)20]}) × (1.07) PV = $2,833,898.81

106.

A loan officer states, "Thousands of dollars can be saved by switching to a 15-year mortgage from a 30-year mortgage." Calculate the difference in payments on a 30-year mortgage at an interest rate of .75% a month versus a 15-year mortgage with an interest rate of .7% a month. Both mortgages are for $100,000 and have monthly payments. What is the difference in total dollars that will be paid to the lender under each loan? (Round the monthly payment amounts to 2 decimal places.) A. $89,211 B. $98,406 C. $113,465 D. $124,300 $100,000 = PMT([1 / (0.0075)] − 1 / {(0.0075)[(1.0075)] 30 × 12}) PMT = $804.62 $100,000 = PMT([1 / (0.007)] − 1 / {(0.007 )[ 1.007)] 15 × 12}) PMT = $ 978.87 Total difference = ($804.62 × 12 × 30) − ($978.87 × 12 × 15) = $113,465

107.

Would you prefer a savings account that paid 7% interest compounded quarterly, 6.8% compounded monthly, 7.2% compounded weekly, or an account that paid 7.5% with annual compounding? A. 7% compounded quarterly B. 6.8% compounded monthly C. 7.2% compounded weekly D. 7.5% compounded annually EAR = [1 + (0.07 / 4)]4 − 1 = 0.0719, or 7.19% EAR = [1 + (0.068 / 12)]12 − 1 = 0.0702, or 7.02% EAR = [1 + (0.072 / 52)]52 − 1 = 0.0746, or 7.46% EAR = APR = 7.5%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic

Learning Objective: 05-04 Compare interest rates quoted over different time intervals-for example; monthly versus annual rates. Topic: Interest rates

108.

After reading the fine print in your credit card agreement, you find that the "low" interest rate is actually an 18% APR, or 1.5% per month. What is the effective annual rate? A. 18.47% B. 19.56% C. 18.82% D. 19.41% EAR = 1.01512 − 1 = 0.1956, or 19.56%

109.

You are considering the purchase of a home that would require a mortgage of $150,000. How much more in total interest will you pay if you select a 30-year mortgage at 5.65% rather than a 15-year mortgage at 4.9%? (Round the monthly payment amount to 2 decimal places.) A. $86,311.18 B. $78,487.92 C. $99,595.80 D. $102,486.68 $150,000 = PMT([1 / (0.0565 / 12)] − 1 / {(0.0565 / 12)[1 + (0.0565 / 12)] 30 × 12}) PMT = $865.85 $150,000 = PMT([1 / (0.049 / 12)] − 1 / {(0.049 / 12)[1 + (0.049 / 12)] 15 × 12}) PMT = $1,178.39 Total difference = ($865.85 ×12 × 30) − ($1,178.39 × 12 × 15) = $99,595.80

110.

Lester's just signed a contract that will provide the firm with annual cash inflows of $28,000, $35,000, and $42,000 over the next three years with the first payment of $28,000 occurring one year from today. What is this contract worth today at a discount rate of 7.25%? A. $88,311.08 B. $89,423.91 C. $90,580.55 D. $91,341.41 PV = $28,000 / 1.0725 + $35,000 / 1.07252 + $42,000 / 1.07253 PV = $90,580.55

111.

Miller's Hardware plans on saving $42,000, $54,000, and $58,000 at the end of each year for the next three years, respectively. How much will the firm have saved at the end of the three years if it can earn 4.5% on its savings? A. $160,295.05 B. $158,098.15 C. $167,508.33 D. $165,212.57 FV = ($42,000 × 1.0452) + ($54,000 × 1.045) + $58,000 FV = $160,295.05

Chapter 05 Test Bank - Static Summary Category AACSB: Analytical Thinking

# of Questions 68

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

111

Blooms: Analyze

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

111

Learning Objective: 05-01 Calculate the future value of money that is invested at a particular interest rate.

Learning Objective: 05-02 Calculate the present value of a future payment.

Learning Objective: 05-03 Calculate present and future values of a level stream of cash payments.

Learning Objective: 05-04 Compare interest rates quoted over different time intervalsfor example; monthly versus annual rates.

Learning Objective: 05-05 Understand the difference between real and nominal cash flows and between real and nominal interest rates.

Topic: Amortization

Topic: Annuities

Topic: Future value-annuity

Topic: Future value-multiple cash flows

Topic: Future value-single cash flow

Topic: Interest rates

Topic: Loan payments

Topic: Nominal and real rates

Topic: Perpetuities

Topic: Present value-annuity

Topic: Present value-multiple cash flows

Topic: Present value-single cash flow

Topic: Simple and compound interest

Chapter 06 Test Bank - Static Student: ___________________________________________________________________________

When a bond matures, the issuer repays the bond’s face value. True

When the market interest rate exceeds the coupon rate, bonds sell for less than face value. True

False

Speculative-grade bonds have default risk; investment grade bonds do not. True

False

Bonds that have a Standard & Poor's rating of BBB or better are considered to be investment-grade bonds. True

False

A long-term investor would more likely be interested in a bond's current yield rather than its yield to maturity. True

False

A bond's bid price will be lower than the ask price. True

False

A bond's rate of return is equal to its coupon payment divided by the price paid for the bond. True

False

Current yield overstates the return of premium bonds since investors who buy a bond at a premium face a capital loss over the life of the bond. True

False

TIPS are unlike most bonds in that their cash flows increase when the national rate of gross domestic product increases. True

False

10. The return to bondholders is guaranteed to equal the yield to maturity only if the bond is held until maturity. True

False

11. It would be realistic to read an ask price listed as 100.127 and a bid price of 100.143. True

False

12. Indexed bonds in the United States are known as Treasury Interest-Paid Securities, or TIPS. True

False

13. The current yield measures the bond's total rate of return. True

False

14. When a financial calculator or spreadsheet program finds a bond's yield to maturity, it uses a trial-and-error process. True

False

15. Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds. True

False

16. Bonds with a rating of Ba or below by Moody's are referred to as speculative grade, high-yield, or junk bonds. True

False

17. Bonds rated BB or above by Standard & Poor's are called investment grade. True

False

18. Bonds rated Ba by Moody's have the same safety rating as the bonds rated BB by Standard & Poor's. True

False

19. Zero-coupon bonds are issued at prices below face value, and the investor's return comes from the difference between the purchase price and the payment of face value at maturity. True

False

20. Issuers compensate investors for default risk by putting a high face value on their bonds. True

False

21. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. True

False

22. Bond ratings measure a bond's credit risk. True

False

23. The coupon rate of a bond equals: A. its yield to maturity. B. a defined percentage of its face value. C. the yield to maturity when the bond sells at a discount. D. the annual interest divided by the current market price. 24. Periodic receipts of interest by the bondholder are known as: A. the coupon rate. B. principal payments. C. coupon payments. D. the default premium.

25. As the coupon rate of a bond increases, the bond's: A. face value increases. B. current price decreases. C. interest payments increase. D. maturity date is extended. 26. Assume a bond is currently selling at par value. What will happen in the future if the yield on the bond is lower than the coupon rate? A. The price of the bond will increase. B. The coupon rate of the bond will increase. C. The par value of the bond will decrease. D. The coupon payments will be adjusted to the new discount rate. 27. If a bond’s asked price is 97.162, the investor: A. receives 97.162% of the stated coupon payments. B. receives $971.62 upon the maturity date of the bond. C. pays 97.162% of face value for the bond. D. pays $10,971.62 for a $10,000 face value bond. 28. How much does the $1,000 to be received upon a bond's maturity in 4 years add to the bond's price if the appropriate discount rate is 6%? A. $209.91 B. $260.00 C. $760.00 D. $792.09 29. What happens to a discount bond as the time to maturity decreases? A. The coupon rate increases. B. The bond price increases. C. The coupon rate decreases. D. The bond price decreases. 30. How much should you pay for a $1,000 bond with 10% coupon, annual payments, and 5 years to maturity if the interest rate is 12%? A. $927.90 B. $981.40 C. $1,000.00 D. $1,075.82

31. How much would an investor expect to pay for a $1,000 par value bond with a 9% annual coupon that matures in 5 years if the interest rate is 7%? A. $696.74 B. $1,075.82 C. $1,082.00 D. $1,123.01 32. Which of the following statements is correct for a 10% coupon bond that has a current yield of 7%? A. The face value of the bond has decreased. B. The bond's maturity value exceeds the bond's price. C. The bond's internal rate of return is 7%. D. The bond's market value is higher than its face value. 33. If an investor purchases a bond when its current yield is higher than the coupon rate, then the bond's price will be expected to: A. decline over time, reaching par value at maturity. B. increase over time, reaching par value at maturity. C. be less than the face value at maturity. D. exceed the face value at maturity. 34. The current yield of a bond can be calculated by: A. multiplying the price by the coupon rate. B. dividing the price by the annual coupon payments. C. dividing the price by the par value. D. dividing the annual coupon payments by the price. 35. What is the current yield of a bond with a 6% coupon, 4 years until maturity, and a price quote of 84? A. 6.00% B. 7.14% C. 5.04% D. 6.38% 36. A bond's par value can also be called its: A. coupon payment. B. present value. C. market value. D. face value. 37. A bond's yield to maturity takes into consideration: A. current yield but not any price changes. B. price changes but not the current yield. C. both the current yield and any price changes. D. neither the current yield nor any price changes.

38. The discount rate that makes the present value of a bond's payments equal to its price is termed the: A. dividend yield. B. yield to maturity. C. current yield. D. coupon rate. 39. What is the coupon rate for a bond with 3 years until maturity, a price of $1,053.46, and a yield to maturity of 6%? Interest is paid annually. A. 6% B. 8% C. 10% D. 11% 40. What is the yield to maturity for a bond paying $100 annually that has 6 years until maturity and sells for $1,000? A. 6.0% B. 8.5% C. 10.0% D. 12.5% 41. Consider a 3-year bond with a par value of $1,000 and an 8% annual coupon. If interest rates change from 8 to 6% the bond's price will: A. increase by $51.54. B. decrease by $51.54. C. increase by $53.46. D. decrease by $53.46. 42. Which one of the following bond values will change when interest rates change? A. The expected cash flows B. The present value C. The coupon payment D. The maturity value 43. What happens to the coupon rate of a $1,000 face value bond that pays $80 annually in interest if market interest rates change from 9% to 10%? A. The coupon rate increases to 10%. B. The coupon rate remains at 9%. C. The coupon rate remains at 8%. D. The coupon rate decreases to 8%. 44. Which one of the following is fixed for the life of a given bond? A. Current price B. Current yield C. Yield to maturity D. Coupon rate

45. What is the rate of return for an investor who pays $1,054.47 for a 3-year bond with an annual coupon payment of 6.5% and sells the bond 1 year later for $1,037.19? A. 4.53% B. 5.33% C. 5.16% D. 4.92% 46. If a bond investor's yield for a particular period does not change, then during that period, the bond's return : A. is zero. B. increases. C. equals the yield. D. is indeterminate. 47. What is the relationship between a bondholder's rate of return and the bond's yield to maturity if he does not hold the bond until it matures? A. The rate of return will be lower than the yield to maturity. B. The rate of return will be higher than the yield to maturity. C. The rate of return will equal the yield to maturity. D. It could be higher or lower. 48. If the coupon rate on an outstanding bond is lower than the relevant current interest rate, then the yield to maturity will be: A. lower than current interest rates. B. equal to the coupon rate. C. higher than the coupon rate. D. lower than the coupon rate. 49. If a 4-year bond with a 7% coupon and a 10% yield to maturity is currently worth $904.90, how much will it be worth 1 year from now if interest rates are constant? A. $904.90 B. $925.39 C. $947.93 D. $1,000.00 50. What price will be paid for a U.S. Treasury bond with an ask price of 135.4062 if the face value is $100,000? A. $100,135.41 B. $135,000.41 C. $136,269.38 D. $135,406.20 51. You purchased a 6% annual coupon bond at face value and sold it one year later for $1,015.16. What was your rate of return on this investment if the face value at maturity was $1,000? A. 4.48% B. 6.15% C. 7.52% D. 6.07%

52. How does a bond dealer generate profits when trading bonds? A. By maintaining bid prices lower than ask prices B. By maintaining bid prices higher than ask prices C. By retaining the bond’s next coupon payment D. By lowering the bond’s coupon rate upon resale 53. A bond is priced at $1,100, has 10 years remaining until maturity, and has a 10% coupon, paid semiannually. What is the amount of the next interest payment? A. $50 B. $55 C. $100 D. $110 54. The yield curve depicts the current relationship between: A. bond yields and default risk. B. bond maturity and bond ratings. C. bond yields and maturity. D. promised yields and default premiums. 55. When the yield curve is upward-sloping, then: A. short-maturity bonds offer the highest coupon rates. B. long-maturity bonds are priced above par value. C. short-maturity bonds yield less than long-maturity bonds. D. long-maturity bonds increase in price when interest rates increase. 56. Nominal U.S. Treasury bond yields: A. are constant over time. B. are equal to the real yields. C. include a default premium. D. include an inflation premium. 57. Which one of these is included in the yield of a bond with a low credit rating but not included in a U.S. Treasury bond yield? Assume both bonds are selling at a premium. A. Real rate of return B. Inflation premium C. Default premium D. Loss of premium 58. The purpose of a floating-rate bond is to: A. save interest expense for corporate issuers. B. avoid making interest payments until maturity. C. shift the yield curve. D. offer rates that adjust to current market conditions.

59. Which of the following would not be associated with a zero-coupon bond? A. Yield to maturity B. Discount bond C. Current yield D. Interest-rate risk 60. Which one of the following bonds would be likely to exhibit a greater degree of interest rate risk? A. A zero-coupon bond with 20 years until maturity B. A coupon-paying bond with 20 years until maturity C. A floating-rate bond with 20 years until maturity D. A zero-coupon bond with 30 years until maturity 61. A "convertible bond" provides the option to convert: A. a bond into shares of common stock. B. fixed-rate coupon payments into variable-rate payments. C. a zero-coupon bond to a coupon-paying bond. D. a junk bond to a zero-coupon investment-grade bond. 62. Rosita purchased a bond for $989 that had a 7% coupon and semiannual interest payments. She sold the bond after 6 months and earned a total return of 4.8% on this investment. At what price, did she sell the bond? A. $1,001.47 B. $974.28 C. $981.06 D. $1,003.18 63. A U.S. Treasury security that pays a fixed coupon and has an initial maturity of 2 to 10 years is called a: A. TIPS. B. Treasury bill. C. Treasury bond. D. Treasury note. 64. Which one of the following must be correct for a bond currently selling at a premium? A. Its coupon rate is variable. B. Its current yield is lower than its coupon rate. C. Its yield to maturity is higher than its coupon rate. D. Its coupon rate is lower than the current market rate on similar bonds. 65. A bond has a coupon rate of 8%, pays interest semiannually, sells for $960, and matures in 3 years. What is its yield to maturity? A. 4.78% B. 5.48% C. 9.57% D. 12.17%

66. Which type of bond is certain to provide a capital loss if held to maturity? A. Discount bond B. Premium bond C. Zero-coupon bond D. Junk bond 67. Investors who purchase bonds having lower credit ratings should expect: A. lower yields to maturity. B. higher default possibilities. C. lower coupon payments. D. higher purchase prices. 68. A bond has a face value of $1,000, has 5 years until maturity, and an annual coupon rate of 7%? It yields 5% currently. By how much will the price change over the next year if the yield remains constant? A. zero B. decline by $86.59 C. decline by $15.67 D. rise by $15.67 69. If a bond is priced at par value, then: A. it has a very low level of default risk. B. its coupon rate equals its yield to maturity. C. it must be a zero-coupon bond. D. the bond is quite close to maturity. 70. The existence of an upward-sloping yield curve suggests that: A. bonds should be selling at a discount to par value. B. bonds will not return as much as common stocks. C. interest rates may be increasing in the future. D. real interest rates will be increasing soon. 71. What is the amount of the annual coupon payment for a bond that has 6 years until maturity, sells for $1,050, and has a yield to maturity of 9.37%? A. $98.64 B. $95.27 C. $101.38 D. $104.97 72. This morning, you purchased a TIPS. Which one of these should you expect to occur if you hold this bond during an inflationary period? A. The coupon payment will increase in real terms. B. The maturity value will increase in nominal terms. C. The market price will remain constant at par. D. The market price will decrease.

73. Many investors may be drawn to municipal bonds because of the bonds': A. speculative grade ratings. B. high coupon payments. C. long periods until maturity. D. income exemption from federal taxes. 74. Two years ago bonds were issued at par with 10 years until maturity and a 7% annual coupon. If interest rates for that grade of bond are currently 8.25%, what will be the market price of these bonds? A. $917.06 B. $928.84 C. $987.50 D. $1,000.00 75. If a bond offers a current yield of 5% and a yield to maturity of 5.45%, then the: A. bond is selling at a discount. B. bond has a high default premium. C. promised yield is not likely to materialize. D. bond must be a Treasury Inflation-Protected Security. 76. What is the total return to an investor who buys a bond for $1,100 when the bond has a 9% annual coupon and 5 years until maturity, then sells the bond after 1 year for $1,085? A. 6.82% B. 6.91% C. 7.64% D. 9.00% 77. How much would an investor lose the first year if she purchased a 30-year zero-coupon bond with a $1,000 par value and a 10% yield to maturity, only to see market interest rates increase to 12% one year later? A. $19.93 B. $20.00 C. $23.93 D. $25.66 78. Assume a bond has been owned by four different investors during its 20-year history. Which one of the following is most likely to have been different for each of these owners? A. Coupon rate B. Coupon frequency C. Par value D. Yield to maturity

79. If an investor purchases a 3%, 5-year TIPS at its par value of $1,000 and the CPI increases 3% over each of the next 5 years, what will be the real value of the principal at maturity? A. $1,000.00 B. $1,030.00 C. $1,060.90 D. $1,061.36 80. Which one of the following is correct concerning real interest rates? A. Real interest rates are constant. B. Real interest rates must be positive. C. Real interest rates must be less than nominal interest rates. D. Real interest rates, if positive, increase purchasing power over time. 81. An investor holds two bonds, one with 5 years until maturity and the other with 20 years until maturity. Which of the following is more likely if interest rates suddenly increase by 2%? A. The 5-year bond will decrease more in price. B. The 20-year bond will decrease more in price. C. Both bonds will decrease in price by the same proportion. D. Neither bond will decrease in price, but their yields will increase. 82. How much should you be prepared to pay for a 10-year bond with an annual coupon of 6% and a yield to maturity of 7.5%? A. $411.84 B. $897.04 C. $985.00 D. $1,000.00 83. How much should you be prepared to pay for a 10-year bond with a 6% coupon, semiannual payments, and a semiannually compounded yield of 7.5%? A. $895.78 B. $897.04 C. $938.40 D. $1,312.66 84. The market price of a bond with 12 years until maturity and an annual coupon rate of 8% increased yesterday. Which one of these may have caused this price increase? A. The bond's rating was downgraded. B. The issuing firm announced the next interest payment. C. The issuing firm announced that its annual earnings met investor expectations. D. Market interest rates decreased.

85. An investor buys a 5-year, 9% coupon bond for $975, holds it for 1 year, and then sells the bond for $985. What was the investor's rate of return? A. 9.00% B. 9.23% C. 9.65% D. 10.26% 86. An investor buys a 10-year, 7% coupon bond for $1,050, holds it for 1 year, and then sells it for $1,040. What was the investor's rate of return? A. 5.71% B. 6.00% C. 6.67% D. 7.00% 87. An investor purchased a fixed-coupon bond at a time when the bond's yield to maturity was 6.9%. The investor sold the bond prior to maturity and realized a total return of 7.1%. Which of these most likely occurred while the investor owned the bond? A. The bond's current yield increased above the bond's coupon rate. B. The inflation rate increased. C. Market interest rates declined. D. Market interest rates increased. 88. A bond has an ask quote of 99.5625 and a bid quote of 99.5475. How much will the bond dealer make on the purchase and resale of a $100,000 bond? A. $150 B. $1,500 C. $15 D. $1.50 89. What are the conditions imposed on a debt issuer that are designed to protect bondholders ? A. Collateral agreements B. Vanilla wrappers C. Protective covenants D. Default provisions 90. The holder of which one of these securities has first claim on the assets of a firm? A. Senior debt B. Common stock C. Subordinated debt D. Preferred stock 91. When market interest rates exceed a bond's coupon rate, the bond will: A. sell for less than par value. B. sell for more than par value. C. decrease its coupon rate. D. increase its coupon rate.

92. Which one of the following is most likely for a CCC-rated bond, compared to a BBB-rated bond? A. The CCC bond will have a variable-coupon rate. B. The CCC bond will have a shorter term. C. The CCC bond will offer a higher promised yield to maturity. D. The CCC bond will have a higher price for the same term. 93. Which of these bond ratings is the lowest of Moody's investment-grade ratings? A. A B. Ba C. Aa D. Baa 94. If a bond offers an investor 11% in nominal return during a year in which the rate of inflation is 4%, then the investor's real return is: A. 6.73%. B. 6.31%. C. 15.44%. D. 10.56%. 95. What nominal return would an investor need to receive if he desires a real return of 4% and the rate of inflation is 5%? A. 4.20% B. 8.64% C. 9.00% D. 9.20% 96. If you purchase a 5-year, zero-coupon bond for $691.72, how much could it be sold for 3 years later if interest rates have remained stable? A. $848.12 B. $923.50 C. $862.92 D. $911.15 97. An investor buys a 10-year annual coupon bond at a yield of 8.7% and sells it 2 years later when it still yields 8.7%. What is his rate of return over this period? A. zero. B. 8.7%. C. Can’t say without knowing the coupon. D. 17.4%. 98. What causes bonds to sell for a premium? A. Investment-quality ratings B. Long periods until maturity C. Coupon rates that exceed market rates D. Speculative-grade ratings

99. The current yield tends to overstate a bond's total return when the bond sells for a premium because: A. the bond's price will decline each year. B. coupon payments can change at any time. C. bonds selling for a premium have low default risk. D. taxes must be paid on the current yield. 100. The current yield tends to understate a bond's total return when the bond sells for a discount because: A. increases in interest rates will increase the current yield. B. the bond's price will increase each year. C. current yields show only nominal returns. D. the bond may have a higher face value. 101. When comparing a highly liquid bond with a comparable but less liquid bond, the highly liquid bond is most apt to have: A. a lower yield. B. a shorter maturity. C. a higher yield. D. a longer maturity. 102. Which one of these statements is not correct? A. When a foreign government borrows dollars, investors worry that in some future crisis the government will not have sufficient dollars to repay the debt. B. When the Japanese government borrows yen, investors worry that in some future crisis the government will not have sufficient yen to repay the debt. C. When a Eurozone government borrows euros, investors worry that in some future crisis the government will not have sufficient euros to repay the debt. D. When the U.S. government issues Treasury bonds, investors never need to worry that they will not be paid back.

Chapter 06 Test Bank - Static Key 1.

When a bond matures, the issuer repays the bond’s face value. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond features

When the market interest rate exceeds the coupon rate, bonds sell for less than face value. TRUE

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond valuation

Current yield overstates the return of premium bonds since investors who buy a bond at a premium face a capital loss over the life of the bond. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

A bond's rate of return is equal to its coupon payment divided by the price paid for the bond. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

A bond's bid price will be lower than the ask price. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond quotes and trading

A long-term investor would more likely be interested in a bond's current yield rather than its yield to maturity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

Bonds that have a Standard & Poor's rating of BBB or better are considered to be investment-grade bonds. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

Speculative-grade bonds have default risk; investment grade bonds do not. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

TIPS are unlike most bonds in that their cash flows increase when the national rate of gross domestic product increases. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Bond types

10.

The return to bondholders is guaranteed to equal the yield to maturity only if the bond is held until maturity. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic

Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

11.

It would be realistic to read an ask price listed as 100.127 and a bid price of 100.143. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond quotes and trading

12.

Indexed bonds in the United States are known as Treasury Interest-Paid Securities, or TIPS. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Bond types

13.

The current yield measures the bond's total rate of return. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

14.

When a financial calculator or spreadsheet program finds a bond's yield to maturity, it uses a trial-and-error process. TRUE AACSB: Technology Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

15.

Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-04 Understand why investors draw a plot of bond yields against maturity. Topic: Bond yields and returns

16.

Bonds with a rating of Ba or below by Moody's are referred to as speculative grade, high-yield, or junk bonds. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

17.

Bonds rated BB or above by Standard & Poor's are called investment grade. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

18.

Bonds rated Ba by Moody's have the same safety rating as the bonds rated BB by Standard & Poor's. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

19.

Zero-coupon bonds are issued at prices below face value, and the investor's return comes from the difference between the purchase price and the payment of face value at maturity. TRUE

20.

Issuers compensate investors for default risk by putting a high face value on their bonds. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

21.

Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

22.

Bond ratings measure a bond's credit risk. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

23.

The coupon rate of a bond equals: A. its yield to maturity. B. a defined percentage of its face value. C. the yield to maturity when the bond sells at a discount. D. the annual interest divided by the current market price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

24.

Periodic receipts of interest by the bondholder are known as: A. the coupon rate. B. principal payments. C. coupon payments. D. the default premium. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond coupons

25.

As the coupon rate of a bond increases, the bond's: A. face value increases. B. current price decreases. C. interest payments increase. D. maturity date is extended. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond coupons

26.

Assume a bond is currently selling at par value. What will happen in the future if the yield on the bond is lower than the coupon rate? A. The price of the bond will increase. B. The coupon rate of the bond will increase. C. The par value of the bond will decrease. D. The coupon payments will be adjusted to the new discount rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

27.

If a bond’s asked price is 97.162, the investor: A. receives 97.162% of the stated coupon payments. B. receives $971.62 upon the maturity date of the bond. C. pays 97.162% of face value for the bond. D. pays $10,971.62 for a $10,000 face value bond.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond quotes and trading

28.

How much does the $1,000 to be received upon a bond's maturity in 4 years add to the bond's price if the appropriate discount rate is 6%?

A. $209.91 B. $260.00 C. $760.00 D. $792.09 $1,000 / 1.064 = $792.09

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond valuation

29.

What happens to a discount bond as the time to maturity decreases? A. The coupon rate increases. B. The bond price increases. C. The coupon rate decreases. D. The bond price decreases.

30.

How much should you pay for a $1,000 bond with 10% coupon, annual payments, and 5 years to maturity if the interest rate is 12%? A. $927.90 B. $981.40 C. $1,000.00 D. $1,075.82 Price = (0.10 × $1,000) {(1 / 0.12) − [1 / 0.12(1.12)5]} + $1,000/1.125 Price = $927.90

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium

Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond valuation

31.

How much would an investor expect to pay for a $1,000 par value bond with a 9% annual coupon that matures in 5 years if the interest rate is 7%? A. $696.74 B. $1,075.82 C. $1,082.00 D. $1,123.01 Price = (0.09 × $1,000) {(1 / 0.07) − [1 / 0.07(1.07)5]} + $1,000 / 1.075 Price = $1,082.00

32.

Which of the following statements is correct for a 10% coupon bond that has a current yield of 7%? A. The face value of the bond has decreased. B. The bond's maturity value exceeds the bond's price. C. The bond's internal rate of return is 7%. D. The bond's market value is higher than its face value.

33.

If an investor purchases a bond when its current yield is higher than the coupon rate, then the bond's price will be expected to: A. decline over time, reaching par value at maturity. B. increase over time, reaching par value at maturity. C. be less than the face value at maturity. D. exceed the face value at maturity.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in

opposite directions. Topic: Interest rate risk

34.

The current yield of a bond can be calculated by: A. multiplying the price by the coupon rate. B. dividing the price by the annual coupon payments. C. dividing the price by the par value. D. dividing the annual coupon payments by the price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

35.

What is the current yield of a bond with a 6% coupon, 4 years until maturity, and a price quote of 84? A. 6.00% B. 7.14% C. 5.04% D. 6.38% Current yield = $60 / (0.84 × $1,000) = 0.0714, or 7.14%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

36.

A bond's par value can also be called its: A. coupon payment. B. present value. C. market value. D. face value. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond features

37.

A bond's yield to maturity takes into consideration: A. current yield but not any price changes. B. price changes but not the current yield. C. both the current yield and any price changes. D. neither the current yield nor any price changes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

38.

The discount rate that makes the present value of a bond's payments equal to its price is termed the: A. dividend yield. B. yield to maturity. C. current yield. D. coupon rate. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

39.

What is the coupon rate for a bond with 3 years until maturity, a price of $1,053.46, and a yield to maturity of 6%? Interest is paid annually. A. 6% B. 8% C. 10% D. 11% $1,053.46 = PMT {(1 / 0.06) − [1 / 0.06(1.16) 3]} + $1,000 / 1.063 PMT = $80 Coupon rate = $80 / $1,000 = 0.08, or 8%

40.

What is the yield to maturity for a bond paying $100 annually that has 6 years until maturity and sells for $1,000? A. 6.0% B. 8.5% C. 10.0% D. 12.5% Since the bond is selling at par, the yield to maturity must equal the coupon rate which is: Coupon rate = $100 / $1,000 = 0.10, or 10%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond yields and returns

41.

Consider a 3-year bond with a par value of $1,000 and an 8% annual coupon. If interest rates change from 8 to 6% the bond's price will: A. increase by $51.54. B. decrease by $51.54. C. increase by $53.46. D. decrease by $53.46. Price = (0.08 × $1,000) {(1 / 0.06) − [1 / 0.06(1.06)3]} + $1,000 / 1.063 Price = $1,053.46 This is a price increase of $53.46, since the bond had sold at par.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

42.

Which one of the following bond values will change when interest rates change? A. The expected cash flows B. The present value C. The coupon payment D. The maturity value AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

43.

What happens to the coupon rate of a $1,000 face value bond that pays $80 annually in interest if market interest rates change from 9% to 10%? A. The coupon rate increases to 10%. B. The coupon rate remains at 9%. C. The coupon rate remains at 8%. D. The coupon rate decreases to 8%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond coupons

44.

Which one of the following is fixed for the life of a given bond? A. Current price B. Current yield C. Yield to maturity D. Coupon rate AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond coupons

45.

What is the rate of return for an investor who pays $1,054.47 for a 3-year bond with an annual coupon payment of 6.5% and sells the bond 1 year later for $1,037.19? A. 4.53% B. 5.33% C. 5.16% D. 4.92% Rate of return = [$1,037.19 + (0.065 × $1,000) − $1,054.47] / $1,054.47 = 0.0453, or 4.53%

46.

If a bond investor's yield for a particular period does not change, then during that period, the bond's return : A. is zero. B. increases. C. equals the yield. D. is indeterminate.

47.

What is the relationship between a bondholder's rate of return and the bond's yield to maturity if he does not hold the bond until it matures? A. The rate of return will be lower than the yield to maturity. B. The rate of return will be higher than the yield to maturity. C. The rate of return will equal the yield to maturity. D. It could be higher or lower.

48.

If the coupon rate on an outstanding bond is lower than the relevant current interest rate, then the yield to maturity will be: A. lower than current interest rates. B. equal to the coupon rate. C. higher than the coupon rate. D. lower than the coupon rate.

49.

If a 4-year bond with a 7% coupon and a 10% yield to maturity is currently worth $904.90, how much will it be worth 1 year from now if interest rates are constant? A. $904.90 B. $925.39 C. $947.93 D. $1,000.00 Price = (0.07 × $1,000) {(1 / 0.10) − [1 / 0.10(1.10)3]} + $1,000 / 1.103 Price = $925.39

50.

What price will be paid for a U.S. Treasury bond with an ask price of 135.4062 if the face value is $100,000? A. $100,135.41 B. $135,000.41 C. $136,269.38 D. $135,406.20 Price = 1.354062 × $100,000 = $135,406.20

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond quotes and trading

51.

You purchased a 6% annual coupon bond at face value and sold it one year later for $1,015.16. What was your rate of return on this investment if the face value at maturity was $1,000? A. 4.48% B. 6.15% C. 7.52% D. 6.07% Rate of return = [$1,015.16 + (0.06 × $1,000) − $1,000] / $1,000 = 0.0752, or 7.52%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium

52.

How does a bond dealer generate profits when trading bonds? A. By maintaining bid prices lower than ask prices B. By maintaining bid prices higher than ask prices C. By retaining the bond’s next coupon payment D. By lowering the bond’s coupon rate upon resale AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond quotes and trading

53.

A bond is priced at $1,100, has 10 years remaining until maturity, and has a 10% coupon, paid semiannually. What is the amount of the next interest payment? A. $50 B. $55 C. $100 D. $110 Coupon payment = (0.10 × $1,000) / 2 = $50

54.

The yield curve depicts the current relationship between: A. bond yields and default risk. B. bond maturity and bond ratings. C. bond yields and maturity. D. promised yields and default premiums. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-04 Understand why investors draw a plot of bond yields against maturity. Topic: Treasury yield curve

55.

When the yield curve is upward-sloping, then: A. short-maturity bonds offer the highest coupon rates. B. long-maturity bonds are priced above par value. C. short-maturity bonds yield less than long-maturity bonds. D. long-maturity bonds increase in price when interest rates increase. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-04 Understand why investors draw a plot of bond yields against maturity. Topic: Treasury yield curve

56.

Nominal U.S. Treasury bond yields: A. are constant over time. B. are equal to the real yields. C. include a default premium. D. include an inflation premium. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond yields and returns

57.

Which one of these is included in the yield of a bond with a low credit rating but not included in a U.S. Treasury bond yield? Assume both bonds are selling at a premium. A. Real rate of return B. Inflation premium C. Default premium D. Loss of premium AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond yields and returns

58.

The purpose of a floating-rate bond is to: A. save interest expense for corporate issuers. B. avoid making interest payments until maturity. C. shift the yield curve. D. offer rates that adjust to current market conditions. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity.

Topic: Bond types

59.

Which of the following would not be associated with a zero-coupon bond? A. Yield to maturity B. Discount bond C. Current yield D. Interest-rate risk AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond types

60.

Which one of the following bonds would be likely to exhibit a greater degree of interest rate risk? A. A zero-coupon bond with 20 years until maturity B. A coupon-paying bond with 20 years until maturity C. A floating-rate bond with 20 years until maturity D. A zero-coupon bond with 30 years until maturity AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Bond yields and returns

61.

A "convertible bond" provides the option to convert: A. a bond into shares of common stock. B. fixed-rate coupon payments into variable-rate payments. C. a zero-coupon bond to a coupon-paying bond. D. a junk bond to a zero-coupon investment-grade bond. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond features

62.

Rosita purchased a bond for $989 that had a 7% coupon and semiannual interest payments. She sold the bond after 6 months and earned a total return of 4.8% on this investment. At what price, did she sell the bond? A. $1,001.47 B. $974.28 C. $981.06 D. $1,003.18 0.048 = (Selling price + [(0.07 × $1,000) / 2] − $989) / $989 Selling price = $1,001.47

63.

A U.S. Treasury security that pays a fixed coupon and has an initial maturity of 2 to 10 years is called a: A. TIPS. B. Treasury bill. C. Treasury bond. D. Treasury note. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond features

64.

Which one of the following must be correct for a bond currently selling at a premium? A. Its coupon rate is variable. B. Its current yield is lower than its coupon rate. C. Its yield to maturity is higher than its coupon rate. D. Its coupon rate is lower than the current market rate on similar bonds.

65.

A bond has a coupon rate of 8%, pays interest semiannually, sells for $960, and matures in 3 years. What is its yield to maturity? A. 4.78% B. 5.48% C. 9.57% D. 12.17% Using a financial calculator: n = 6; PV = −$960; PMT = $40; FV = $1,000, CPT i = 4.7826% YTM = 2 × 4.7826% = 9.57%

AACSB: Technology Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond yields and returns

66.

Which type of bond is certain to provide a capital loss if held to maturity? A. Discount bond B. Premium bond C. Zero-coupon bond D. Junk bond

67.

Investors who purchase bonds having lower credit ratings should expect: A. lower yields to maturity. B. higher default possibilities. C. lower coupon payments. D. higher purchase prices. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

68.

A bond has a face value of $1,000, has 5 years until maturity, and an annual coupon rate of 7%? It yields 5% currently. By how much will the price change over the next year if the yield remains constant? A. zero B. decline by $86.59 C. decline by $15.67 D. rise by $15.67 Price today = $70(1 / 0.05+1 / (0.05 × 1.054)) + $1,070 / 1.055 = $1,086.59 Price next year = $70(1 / 0.05+1 / (0.05 × 1.053)) + $1,070 / 1.054 = $1,070.92 Price declines by $15.67

69.

If a bond is priced at par value, then: A. it has a very low level of default risk. B. its coupon rate equals its yield to maturity. C. it must be a zero-coupon bond. D. the bond is quite close to maturity.

70.

The existence of an upward-sloping yield curve suggests that: A. bonds should be selling at a discount to par value. B. bonds will not return as much as common stocks. C. interest rates may be increasing in the future. D. real interest rates will be increasing soon.

71.

What is the amount of the annual coupon payment for a bond that has 6 years until maturity, sells for $1,050, and has a yield to maturity of 9.37%? A. $98.64 B. $95.27 C. $101.38 D. $104.97 $1,050 = PMT {(1 / 0.0937) − [1 / 0.0937(1.0937)6]} + $1,000 / 1.09376 PMT = $104.97

72.

This morning, you purchased a TIPS. Which one of these should you expect to occur if you hold this bond during an inflationary period? A. The coupon payment will increase in real terms. B. The maturity value will increase in nominal terms. C. The market price will remain constant at par. D. The market price will decrease. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Bond valuation

73.

Many investors may be drawn to municipal bonds because of the bonds': A. speculative grade ratings. B. high coupon payments. C. long periods until maturity. D. income exemption from federal taxes. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond features

74.

Two years ago bonds were issued at par with 10 years until maturity and a 7% annual coupon. If interest rates for that grade of bond are currently 8.25%, what will be the market price of these bonds? A. $917.06 B. $928.84 C. $987.50 D. $1,000.00 Price = (0.07 × $1,000) {(1 / 0.0825) − [1 / 0.0825(1.0825)10 − 2]} + $1,000 / 1.082510 − 2

75.

If a bond offers a current yield of 5% and a yield to maturity of 5.45%, then the: A. bond is selling at a discount. B. bond has a high default premium. C. promised yield is not likely to materialize. D. bond must be a Treasury Inflation-Protected Security.

76.

What is the total return to an investor who buys a bond for $1,100 when the bond has a 9% annual coupon and 5 years until maturity, then sells the bond after 1 year for $1,085? A. 6.82% B. 6.91% C. 7.64% D. 9.00% Total return = [$1,085 + (0.09 × $1,000) − $1,100] / $1,100 = 0.0682, or 6.82%

77.

How much would an investor lose the first year if she purchased a 30-year zero-coupon bond with a $1,000 par value and a 10% yield to maturity, only to see market interest rates increase to 12% one year later? A. $19.93 B. $20.00 C. $23.93 D. $25.66 Price = $1,000 / 1.1030 = $57.31 New price = $1,000 / 1.1229 = $37.38 Loss = $57.31 − 37.38 = $19.93

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond valuation

78.

Assume a bond has been owned by four different investors during its 20-year history. Which one of the following is most likely to have been different for each of these owners? A. Coupon rate B. Coupon frequency C. Par value D. Yield to maturity AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity. Topic: Bond yields and returns

79.

If an investor purchases a 3%, 5-year TIPS at its par value of $1,000 and the CPI increases 3% over each of the next 5 years, what will be the real value of the principal at maturity? A. $1,000.00 B. $1,030.00 C. $1,060.90 D. $1,061.36 The real value of the principal will remain constant at the par value.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium

Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Bond features

80.

Which one of the following is correct concerning real interest rates? A. Real interest rates are constant. B. Real interest rates must be positive. C. Real interest rates must be less than nominal interest rates. D. Real interest rates, if positive, increase purchasing power over time. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Nominal and real rates

81.

An investor holds two bonds, one with 5 years until maturity and the other with 20 years until maturity. Which of the following is more likely if interest rates suddenly increase by 2%? A. The 5-year bond will decrease more in price. B. The 20-year bond will decrease more in price. C. Both bonds will decrease in price by the same proportion. D. Neither bond will decrease in price, but their yields will increase. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

82.

How much should you be prepared to pay for a 10-year bond with an annual coupon of 6% and a yield to maturity of 7.5%? A. $411.84 B. $897.04 C. $985.00 D. $1,000.00 Price = (0.06 × $1,000) {(1 / 0.075) − [1 / 0.075(1.075)10]} + $1,000 / 1.07510 Price = $897.04

83.

How much should you be prepared to pay for a 10-year bond with a 6% coupon, semiannual payments, and a semiannually compounded yield of 7.5%? A. $895.78 B. $897.04 C. $938.40 D. $1,312.66 Semiannual interest rate = 0.075 / 2 = 0.0375 Price = [(0.06 / 2) × $1,000)] {(1 / 0.0375) − [1 / 0.0375(1.0375) 10 × 2]} + $1,000 / 1.037510 × 2 Price = $895.78

84.

The market price of a bond with 12 years until maturity and an annual coupon rate of 8% increased yesterday. Which one of these may have caused this price increase? A. The bond's rating was downgraded. B. The issuing firm announced the next interest payment. C. The issuing firm announced that its annual earnings met investor expectations. D. Market interest rates decreased. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

85.

An investor buys a 5-year, 9% coupon bond for $975, holds it for 1 year, and then sells the bond for $985. What was the investor's rate of return? A. 9.00% B. 9.23% C. 9.65% D. 10.26% Rate of return = [$985 + (0.09 × $1,000) − $975] / $975 = 0.1026, or 10.26%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium

86.

An investor buys a 10-year, 7% coupon bond for $1,050, holds it for 1 year, and then sells it for $1,040. What was the investor's rate of return? A. 5.71% B. 6.00% C. 6.67% D. 7.00% Rate of return = [$1,040 + (0.07 × $1,000) − $1,050] / $1,050 = 0.0571, or 5.71%

87.

An investor purchased a fixed-coupon bond at a time when the bond's yield to maturity was 6.9%. The investor sold the bond prior to maturity and realized a total return of 7.1%. Which of these most likely occurred while the investor owned the bond? A. The bond's current yield increased above the bond's coupon rate. B. The inflation rate increased. C. Market interest rates declined. D. Market interest rates increased. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

88.

A bond has an ask quote of 99.5625 and a bid quote of 99.5475. How much will the bond dealer make on the purchase and resale of a $100,000 bond? A. $150 B. $1,500 C. $15 D. $1.50 Dealer profit = (0.995625 − 0.995475) × $100,000 = $15

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity.

Topic: Bond quotes and trading

89.

What are the conditions imposed on a debt issuer that are designed to protect bondholders ? A. Collateral agreements B. Vanilla wrappers C. Protective covenants D. Default provisions AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond features

90.

The holder of which one of these securities has first claim on the assets of a firm? A. Senior debt B. Common stock C. Subordinated debt D. Preferred stock AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond features

91.

When market interest rates exceed a bond's coupon rate, the bond will: A. sell for less than par value. B. sell for more than par value. C. decrease its coupon rate. D. increase its coupon rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

92.

Which one of the following is most likely for a CCC-rated bond, compared to a BBB-rated bond? A. The CCC bond will have a variable-coupon rate. B. The CCC bond will have a shorter term. C. The CCC bond will offer a higher promised yield to maturity. D. The CCC bond will have a higher price for the same term. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic

Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

93.

Which of these bond ratings is the lowest of Moody's investment-grade ratings? A. A B. Ba C. Aa D. Baa AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Bond ratings and credit risk

94.

If a bond offers an investor 11% in nominal return during a year in which the rate of inflation is 4%, then the investor's real return is: A. 6.73%. B. 6.31%. C. 15.44%. D. 10.56%. 1 + real return = 1.11 / 1.04 − 1 = 0.0673, or 6.73%

95.

What nominal return would an investor need to receive if he desires a real return of 4% and the rate of inflation is 5%? A. 4.20% B. 8.64% C. 9.00% D. 9.20% Nominal return = (1.04 ×1.05) − 1 = 0.0920, or 9.20%

96.

If you purchase a 5-year, zero-coupon bond for $691.72, how much could it be sold for 3 years later if interest rates have remained stable? A. $848.12 B. $923.50 C. $862.92 D. $911.15 $691.72 = $1,000 / (1 + i)5 i = 0.0765 Price = $1,000 / 1.07652 Price = $862.92

97.

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

98.

What causes bonds to sell for a premium? A. Investment-quality ratings B. Long periods until maturity C. Coupon rates that exceed market rates D. Speculative-grade ratings AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 06-03 Show why bonds exhibit interest rate risk. Topic: Interest rate risk

99.

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

100.

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

101.

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

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions. Topic: Bond yields and returns

102.

Which one of these statements is not correct? A. When a foreign government borrows dollars, investors worry that in some future crisis the government will not have sufficient dollars to repay the debt. B. When the Japanese government borrows yen, investors worry that in some future crisis the government will not have sufficient yen to repay the debt. C. When a Eurozone government borrows euros, investors worry that in some future crisis the government will not have sufficient euros to repay the debt. D. When the U.S. government issues Treasury bonds, investors never need to worry that they will not be paid back. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings. Topic: Sovereign debt

Chapter 06 Test Bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

AACSB: Technology

Accessibility: Keyboard Navigation

102

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

102

Learning Objective: 06-01 Distinguish among a bond’s coupon rate, current yield, and yield to maturity.

Learning Objective: 06-02 Find the market price of a bond given its yield to maturity, find a bond’s yield given its price, and demonstrate why prices and yields move in opposite directions.

Learning Objective: 06-03 Show why bonds exhibit interest rate risk.

Learning Objective: 06-04 Understand why investors draw a plot of bond yields against maturity.

Learning Objective: 06-05 Understand why investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings.

Topic: Bond coupons

Topic: Bond features

Topic: Bond quotes and trading

Topic: Bond ratings and credit risk

Topic: Bond types

Topic: Bond valuation

Topic: Bond yields and returns

Topic: Interest rate risk

Topic: Nominal and real rates

Topic: Sovereign debt

Topic: Treasury yield curve

Chapter 07 Test Bank - Static Student: ___________________________________________________________________________

An excess of market value over the book value of equity can be attributed to going concern value. True

False

Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout ratio. True

False

The liquidation value of a firm is equal to the book value of the firm. True

False

If the stock prices follow a random walk, successive stock prices are not related. True

False

The dividend discount model should not be used to value stocks if the dividend does not grow. True

False

If investors believe a company will have the opportunity to make very profitable investments in the future, they will pay more for the company's stock today. True

False

Securities with the same expected risk should offer the same expected rate of return. True

False

If the market is efficient, stock prices should be expected to react only to new information. True

False

10. If stock prices follow a random walk, their prices bear no relation to the company’s real activities. True

False

11. A negative free cash flow for a business is always sign that it is not performing well. True

False

12. Evidence that stock prices follow a random walk does not imply that there aren’t predictable cycles in prices. True

False

13. Market efficiency implies that security prices impound new information quickly. True

False

14. If security prices follow a random walk, then on any particular day the odds are that an increase or decrease in price is about equally likely. True

False

15. Many professional investors attempt to beat the market by buying index funds. True

False

16. Market efficiency implies that one could earn above-average returns by examining the history of a firm's stock price. True

False

17. Market value, unlike book value and liquidation value, treats the firm as a going concern. True

False

18. The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective capital gains or losses. True

False

19. The dividend discount model states that today's stock price equals the present value of all expected future dividends. True

False

20. The growth of mature companies is primarily funded by: A. issuing new shares of stock. B. issuing new debt securities. C. reinvesting company earnings. D. increasing accounts payable. 21. The sustainable growth rate represents the ____ rate at which a firm can grow: A. maximum; while maintaining a constant debt-equity ratio. B. maximum; based solely on internal financing. C. minimum; while maintaining a constant debt-equity ratio. D. minimum; based solely on internal financing.

22. Wilt's has earnings per share of $2.98 and dividends per share of $0.35. What is the firm's sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%? A. 2.14% B. 1.71% C. 12.89% D. 16.06% 23. The sustainable rate of growth: A. increases as the dividend payout ratio increases. B. must be moderate over the long-term even if it is high in the short-term. C. assumes the debt-equity ratio will increase at the same rate as the growth rate. D. must exceed the required rate of return to be used in the dividend discount model. 24. For a firm that repurchases its stock, firm value is most easily estimated by discounting _______________ A. dividends plus repurchases per share. B. repurchases rather than dividends. C. free cash flows. D. pre-repurchase earnings per share. 25. A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8%, and $648,200 in next year’s free cash flow. What value would you place on a share of this firm's stock if you require a 14% rate of return? A. $48.09 B. $52.96 C. $54.02 D. $61.58 26. The semi-strong form of the efficient market hypothesis states that: A. the efficient market hypothesis is only half true. B. professional investors make superior profits but amateurs can’t. C. stock prices do not follow a random walk. D. prices reflect all publicly available information. 27. If the general sentiment of investors is pessimistic, stock prices are more apt to: A. increase significantly. B. increase slightly. C. remain constant. D. decline. 28. Which of these statements is correct? Free cash flow A. is available to be paid out to investors as interest or dividends, or to repay debt or buy back stock. B. is positive if the company is issuing debt or stock. C. is equal to net income. D. is another term for retained earnings.

29. If markets are efficient, when new information about a stock becomes available, the price will: A. remain unchanged because it already reflects this information. B. accurately and rapidly adjust to include this new information. C. adjust to accurately reflect this new information over the course of the next few days. D. most likely increase because all new information has a positive effect on stock prices. 30. Which statement is correct?

A. Stock repurchases invalidate the dividend discount model B. Stock repurchases do not add value to a business and can be ignored. C. When there are repurchases, it is simpler to value a business by discounting the free cash flow. D. Stock repurchases increase the number of shares and make it difficult to forecast dividends per share 31. What dividend yield would be reported in the financial press for a stock that currently pays a $1 dividend per quarter and the most recent stock price was $40? A. 2.5% B. 4.0% C. 10.0% D. 5.0% 32. Which of the following values treats the firm as a going concern? A. Market value B. Book value C. Liquidation value D. Both market and book values 33. If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout ratio is 40%, what is the stock's current price? A. $24.30 B. $18.00 C. $22.22 D. $40.50 34. With respect to the notion that stock prices follow a random walk, many researchers have concluded that: A. stock prices reflect a majority of available information about the firm. B. successive price changes are predictable. C. past stock price changes provide little useful information about future stock price changes. D. stock prices always rise excessively in January.

35. What is the current price of a share of stock for a firm with $5 million in balance-sheet equity, 500,000 shares of stock outstanding, and a price/book value ratio of 4? A. $2.50 B. $10.00 C. $20.00 D. $40.00 36. A firm's liquidation value is the amount: A. necessary to repurchase all outstanding shares of common stock. B. realized from selling all assets and paying off all creditors. C. a purchaser would pay to acquire all of the firm's assets. D. shown on the balance sheet as total owners' equity. 37. Which one of the following is least likely to account for an excess of market value over book value of equity? A. Inaccurate depreciation methods B. High rate of return on assets C. The presence of growth opportunities D. Valuable off-balance sheet assets 38. Firms with valuable intangible assets are more likely to show a(n): A. excess of book value over market value of equity. B. high going-concern value. C. low liquidation value. D. low P/E ratio. 39. Which of the following is inconsistent with a firm that sells for very near book value? A. Low current earnings B. Few, if any, intangible assets C. High future earning power D. Low, unstable dividend payment 40. A stock paying $5 in annual dividends currently sells for $80 and has an expected return of 14%. What might investors expect to pay for the stock one year from now after the next dividend has been paid? A. $82.20 B. $86.20 C. $87.20 D. $91.20 41. A stock currently sells for $50 per share, has an expected return of 15%, and an expected capital appreciation rate of 10%. What is the amount of the expected dividend? A. $2.50 B. $2.75 C. $3.00 D. $3.50

42. The expected return on a common stock is equal to: A. [(1 + dividend yield) × (1 + capital appreciation rate)] − 1. B. the capital appreciation rate + dividend yield. C. (1 + capital appreciation rate)/(1 + dividend yield). D. the capital appreciation rate − dividend yield. 43. It is possible to ignore cash dividends that occur very far into the future when using a dividend discount model because those dividends: A. will most likely be paid to a different investor. B. will most likely not be paid. C. have an insignificant present value. D. have a minimal, if any, potential rate of growth. 44. If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will the year 4 dividend be if dividends grow annually at a constant rate of 6%? A. $1.33 B. $1.49 C. $1.58 D. $1.67 45. Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in five years if the growth rate is 4.2%? A. $7.07 B. $7.37 C. $7.14 D. $7.44 46. The value of common stock will likely decrease if: A. the investment horizon decreases. B. the growth rate of dividends increases. C. the discount rate increases. D. dividends are discounted back to the present. 47. When valuing stock with the dividend discount model, the present value of future dividends will: A. change depending on the time horizon selected. B. remain constant regardless of the time horizon selected. C. remain constant regardless of the rate of growth. D. always equal the present value of the terminal price. 48. What should be the price for a common stock paying $3.50 annually in dividends if the growth rate is zero and the discount rate is 8%? A. $22.86 B. $28.00 C. $42.00 D. $43.75

49. What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the constant-growth rate is 2.85%, and you require a 15.5% rate of return? A. $31.25 B. $38.87 C. $41.50 D. $42.68 50. What price would you pay today for a stock if you require a rate of return of 13%, the dividend growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50? A. $27.55 B. $30.28 C. $26.60 D. $31.37 51. What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's dividend is forecast at $2.20 and the appropriate discount rate is 13.6%? A. 7.02% B. 6.59% C. 6.81% D. 7.38% 52. What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually in dividends, and is expected to sell for $32.80 per share in one year? A. 15.03% B. 14.28% C. 14.09% D. 14.47% 53. ABC common stock is expected to have extraordinary growth in earnings and dividends of 20% per year for 2 years, after which the growth rate will settle into a constant 6%. If the discount rate is 15% and the most recent dividend was $2.50, what should be the approximate current share price? A. $31.16 B. $33.23 C. $37.39 D. $47.77 54. What would be the approximate expected price of a stock when dividends are expected to grow at a 25% rate in each of years 2 and 3, and then grow at a constant rate of 5% if the stock's required return is 13% and next year's dividend will be $4.00? A. $67.60 B. $62.08 C. $68.64 D. $73.44

55. A company with a return on equity of 15% and a plowback ratio of 60% would expect a constant-growth rate of: A. 4%. B. 9%. C. 21%. D. 25%. 56. What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75 per share in dividends? A. 28.20% B. 34.70% C. 66.67% D. 71.80% 57. A positive value for PVGO suggests that the firm has: A. a positive return on equity. B. a positive plowback ratio. C. investment opportunities with superior returns. D. a high rate of constant growth. 58. Which of the following situations accurately describes a growth stock, assuming that each firm has a required return of 12%? A. A firm with PVGO = $0. B. A firm with investment opportunities yielding 10%. C. A firm with investment opportunities yielding 15%. D. A firm with PVGO < $0. 59. Other things equal, a firm's sustainable growth rate could increase as a result of: A. increasing the plowback ratio. B. increasing the payout ratio. C. decreasing the return on equity. D. increasing total assets. 60. Under which of the following forms of market efficiency would stock prices always reflect fair value? A. Weak-form efficiency B. Semi-strong-form efficiency C. Strong-form efficiency D. Semi-weak-form efficiency 61. Investors are willing to purchase stocks having high P/E ratios because: A. they expect these shares to sell for a lower price. B. they expect these shares to offer higher dividend payments. C. these shares are accompanied by guaranteed earnings. D. they expect these shares to have greater growth opportunities.

62. Which of the following is least likely to contribute to going concern value? A. High liquidation value B. Extra earning power C. Future investment opportunities D. Intangible assets 63. What happens to a firm that reinvests its earnings at a rate equal to the firm's required return? A. Its stock price will remain constant. B. Its stock price will increase by the sustainable growth rate. C. Its stock price will decline unless the dividend payout ratio is zero. D. Its stock price will decline unless the plowback rate exceeds the required return. 64. What can be expected to happen when stocks having the same expected risk do not have the same expected return? A. At least one of the stocks becomes temporarily mispriced. B. This is a common occurrence indicating that one stock has more PVGO. C. This cannot happen if the shares are traded in an auction market. D. The expected risk levels will change until the expected returns are equal. 65. The terminal value of a share of stock: A. is similar to the maturity value of a bond. B. refers to the share value at the end of an investor's holding period. C. is the value received by investors upon liquidation of the firm. D. is the price for shares traded through a dealers' market. 66. A stock is expected to pay dividends of $1.20 per share in Year 1 and $1.35 per share in Year 2. After that, the dividend is expected to increase by 2.5% annually. What is the current value of the stock at a discount rate of 14.5%? A. $11.29 B. $10.87 C. $12.07 D. $13.39 67. Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to decrease by 4% each year. How much should you pay for this stock today if your required return is 16%? A. $6.29 B. $5.74 C. $10.48 D. $11.57 68. Which one of the following is more likely to be responsible for a firm having a low PVGO? A. ROE exceeds required return. B. Plowback is very high. C. Market value of equity is close to book value. D. Book value of equity is low.

69. What is the most likely value of the PVGO for a stock with a current price of $50, expected earnings of $6 per share, and a required return of 20%? A. $10 B. $20 C. $25 D. $30 70. What is the expected constant-growth rate of dividends for a stock with a current price of $87, an expected dividend payment of $5.40 per share, and a required return of 16%? A. 8.48% B. 6.25% C. 9.79% D. 5.23% 71. Which of the following is true for a firm having a stock price of $42, an expected dividend of $3, and a sustainable growth rate of 8%? A. It has a required return of 15.14%. B. It has a dividend yield of 7.35%. C. The stock price is expected to be $45 next year. D. It has a capital appreciation rate of 7.14%. 72. What is the value of the expected dividend per share for a stock that has a required return of 16%, a price of $45, and a constantgrowth rate of 12%? A. $1.80 B. $3.60 C. $4.50 D. $7.20 73. What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25, an expected dividend of $2.10, and a P/E ratio of 14.4? A. 12.40% B. 10.92% C. 11.70% D. 11.26% 74. What should be the price of a stock that offers a $4.32 annual dividend with no prospects of growth, and has a required return of 12.5%? A. $0 B. $4.86 C. $34.56 D. $30.24

75. Psychologists have observed that: A. once investors have made a loss, they become much more willing to take risks. B. investors tend to place too much faith in their ability to spot mispriced stocks. C. when forecasting the future, people tend to place too little weight on recent events. D. investors like stocks of companies whose names begin with letters that occur early in the alphabet. 76. If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the stock: A. pays $1 per share per quarter. B. paid $.25 per share per quarter for the past year. C. paid $1 during the past quarter, with no future dividends forecast. D. is expected to pay a dividend of $1 per share at the end of next year. 77. Suzi owns 100 shares of AB stock. She expects to receive a $238 in dividends next year. Investors expect the stock to sell for $46 a share one year from now. What is the intrinsic value of this stock if the dividend payout ratio is 40% and the discount rate is 13.5%? A. $38.19 B. $42.63 C. $40.53 D. $45.77 78. What is the minimum amount shareholders should expect to receive in the event of a complete corporate liquidation? A. Market value of equity B. Book value of equity C. Zero D. Shareholders may be required to pay to be liquidated. 79. If the price of a stock falls on 4 consecutive days of trading, then stock prices: A. cannot be following a random walk. B. can still be following a random walk. C. are almost certain to increase the following day. D. are almost certain to decrease the following day. 80. What should be the stock value one year from today for a stock that currently sells for $35, has a required return of 15%, an expected dividend of $2.80, and a constant dividend growth rate of 7%? A. $37.45 B. $37.80 C. $40.25 D. $43.05 81. The required return on an equity security is comprised of a: A. dividend yield and ROE. B. current yield and a terminal value. C. sustainable growth rate and a plowback yield. D. dividend yield and a capital gains yield.

82. What should be the current price of a share of stock if a $5 dividend was just paid, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A. $19.23 B. $25.00 C. $35.71 D. $37.86 83. What should be the current price of a stock if the expected dividend is $5, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A. $19.23 B. $25.00 C. $35.71 D. $37.86 84. Reinvesting earnings into a firm will not increase the stock price unless: A. the new paradigm of stock pricing is maintained. B. true depreciation is less than reported depreciation. C. the firm's dividends are growing also. D. the return on the new investments exceeds the firm's required return. 85. What proportion of earnings is being plowed back into the firm if the sustainable growth rate is 8% and the firm's ROE is 20%? A. 60% B. 80% C. 20% D. 40% 86. How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an expected dividend of $2.50, and a required return of 20%? A. $0 B. $6 C. $8 D. $10 87. What is the expected constant-growth rate of dividends for a stock currently priced at $50, that just paid a dividend of $4, and has a required return of 18%? A. 3.41% B. 5.50% C. 9.26% D. 12.5%

88. According to random-walk theory, what are the (approximate) odds that a stock will increase in price after having increased on two consecutive days of trading? A. 0% B. 25% C. 50% D. 100% 89. If the liquidation value of a corporation exceeds the market value of the equity, then the: A. firm has no value as a going concern. B. firm's stock will sell for book value. C. firm is not taking advantage of available growth opportunities. D. dividend payout ratio has been too high. 90. In a valuation of a nonconstant dividend growth stock, the terminal value represents the: A. point at which the present value of future dividends equals zero. B. maturity date of the stock. C. present value of future dividends from that point on. D. highest value that the stock will attain. 91. Which one of the following situations is most likely to occur today for a stock that went down in price yesterday? A. The stock will increase in price. B. The stock will decrease in price. C. The stock has a 30% chance of decreasing in price. D. The stock has no predictable price-change pattern. 92. Based on the random walk theory, if a stock's price decreased last week, then this week the price:

A. will reverse last week's loss and go up. B. will continue last week's decline. C. will stand still until new information is released. D. has an equal chance of going either up or down. 93. Research indicates that the correlation coefficient between successive days' stock price changes is: A. quite close to +1. B. quite close to C. quite close to zero. D. directly related to the stock's beta. 94. An analyst who relies on past cycles of stock pricing to make investment decisions is: A. performing fundamental analysis. B. relying on strong-form market efficiency. C. assuming that the market is not even weak-form efficient. D. relying on the random walk of stock prices.

95. Which statement is correct? A. When stock prices barely change for a while, they are said to be stuck in a "bubble." B. Bubbles can result when prices rise rapidly and investors join the game on the assumption that prices will continue to rise. C. Most bubbles with hindsight can be justified by the improved fundamentals. D. "Bubbles" is another term for stocks in high-tech industries. 96. If it proves possible to make abnormal profits based on information regarding past stock prices, then the market is: A. weak-form efficient. B. not weak-form efficient. C. semi strong-form efficient. D. strong-form efficient. 97. Which statement is correct? A. The momentum factor refers to the tendency for stock price changes to reverse. B. The momentum factor refers to the tendency for stock price changes to persist for a while and then revert. C. The momentum factor implies that stock prices are rather like a pendulum. D. The momentum factor is inconsistent with the strong form of the efficient market hypothesis. 98. Which statement is correct? A. It is much easier to judge whether the absolute level of stock prices is correct rather than whether their relative levels are correct. B. It is much easier to judge whether relative stock prices are correct than to judge whether their absolute level is correct. C. Most tests of market efficiency are concerned with the absolute level of stock prices. D. If relative prices are correct, then absolute prices must be correct also. 99. Market efficiency implies A. that investors are irrational. B. that there is no point to buying common stocks. C. that consistently superior performance is very difficult even for professional investors. D. that there are no taxes. 100. If no price change occurs in a stock on the day that it announces its next dividend, it can be assumed that: A. the stock market is inefficient. B. the dividend was reduced. C. the market was expecting this information. D. technical analysts are not following this stock. 101. When investors are not capable of making superior investment decisions on a consistent basis based on past prices or public or private information, the market is said to be: A. weak-form efficient. B. semi strong-form efficient. C. strong-form efficient. D. fundamentally efficient.

102. Evidence that newly issued stocks tend to underperform the market over the following years: A. is a natural result of risk aversion. B. is exactly what you would expect in an efficient market. C. is inconsistent with the semi-strong form of the efficient market hypothesis. D. is evidence against the random walk hypothesis. 103. For corporate financial managers an important lesson of market efficiency is: A. Trust market prices unless you have a clear advantage that ensures the odds are in your favor. B. Issue stock after a rise in price. C. Be on the lookout for undervalued companies to take over. D. Your company should be able to make healthy profits from its foreign exchange dealings. 104. When new information becomes available in the market, evidence generally suggests that: A. insiders will be the only investors to gain. B. it takes at least ten trading days for stock prices to adjust. C. stock prices will adjust to the information rapidly. D. transaction costs will erase any benefit of trading on the information. 105. Suppose that the total value of dividends to be paid by companies in the Narnian stock market index is $100 billion. Investors expect dividends to grow over the long term by 5% annually, and they require a 10% return. Now a collapse in the economy leads investors to revise their growth estimate down to 4%. By how much should market values change? A. −16.67%. B. zero. C. −20%. D. +20%. 106. Your broker suggests that you can make consistent, excess profits by purchasing stocks on the 20 th of the month and selling them on the last day of the month. If this is true, then: A. the market is only semi strong-form efficient. B. the market violates even weak-form efficiency. C. insiders will be the only investors to profit. D. prices follow a random walk. 107. If a firm unexpectedly raises its dividend permanently and by a substantial amount, the firm's stock price: A. should rise, given dividend discount models. B. should decline, given discounted cash flow analysis. C. will remain constant, due to market efficiency. D. remain constant, due to random-walk behavior. 108. The statement that there are no free lunches on Wall Street suggests that: A. the market is strong-form efficient. B. there is no return to technical or fundamental analysis. C. security prices reflect all available information. D. food stocks offer the lowest rates of return.

Chapter 07 Test Bank - Static Key 1.

The dividend discount model states that the value of a stock is the present value of the dividends it will pay over the investor's horizon, plus the present value of the expected stock price at the end of that horizon. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Dividend discount model

An excess of market value over the book value of equity can be attributed to going concern value. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Market and book values

Securities with the same expected risk should offer the same expected rate of return. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Risk and return relationship

If investors believe a company will have the opportunity to make very profitable investments in the future, they will pay more for the company's stock today. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Dividend discount model

The dividend discount model should not be used to value stocks if the dividend does not grow. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Dividend discount model

If the stock prices follow a random walk, successive stock prices are not related. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

The liquidation value of a firm is equal to the book value of the firm. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Market and book values

Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout ratio. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Internal and sustainable growth rates

If the market is efficient, stock prices should be expected to react only to new information. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-foundations and types

10.

If stock prices follow a random walk, their prices bear no relation to the company’s real activities. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

11.

A negative free cash flow for a business is always sign that it is not performing well. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-03 Apply valuation models to an entire business. Topic: Valuing an entire business

12.

Evidence that stock prices follow a random walk does not imply that there aren’t predictable cycles in prices. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

13.

Market efficiency implies that security prices impound new information quickly. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

14.

If security prices follow a random walk, then on any particular day the odds are that an increase or decrease in price is about equally likely. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

15.

Many professional investors attempt to beat the market by buying index funds. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-studies and challenges

16.

Market efficiency implies that one could earn above-average returns by examining the history of a firm's stock price. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-foundations and types

17.

Market value, unlike book value and liquidation value, treats the firm as a going concern. TRUE

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Market and book values

18.

The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective capital gains or losses. TRUE

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Stock returns and yields

19.

The dividend discount model states that today's stock price equals the present value of all expected future dividends. TRUE

AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios.

20.

The growth of mature companies is primarily funded by: A. issuing new shares of stock. B. issuing new debt securities. C. reinvesting company earnings. D. increasing accounts payable.

21.

The sustainable growth rate represents the ____ rate at which a firm can grow: A. maximum; while maintaining a constant debt-equity ratio. B. maximum; based solely on internal financing. C. minimum; while maintaining a constant debt-equity ratio. D. minimum; based solely on internal financing.

22.

Wilt's has earnings per share of $2.98 and dividends per share of $0.35. What is the firm's sustainable rate of growth if its return on assets is 14.6% and its return on equity is 18.2%? A. 2.14% B. 1.71% C. 12.89% D. 16.06% Sustainable growth rate = ROE × plowback ratio Sustainable growth rate = 0.182 × [($2.98 − 0.35)/$2.98] Sustainable growth rate = 0.1606, or 16.06%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Dividend discount model

23.

The sustainable rate of growth: A. increases as the dividend payout ratio increases. B. must be moderate over the long-term even if it is high in the short-term. C. assumes the debt-equity ratio will increase at the same rate as the growth rate. D. must exceed the required rate of return to be used in the dividend discount model.

24.

For a firm that repurchases its stock, firm value is most easily estimated by discounting _______________ A. dividends plus repurchases per share. B. repurchases rather than dividends. C. free cash flows. D. pre-repurchase earnings per share. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-03 Apply valuation models to an entire business. Topic: Dividend discount model

25.

A firm has 120,000 shares of stock outstanding, a sustainable rate of growth of 3.8%, and $648,200 in next year’s free cash flow. What value would you place on a share of this firm's stock if you require a 14% rate of return? A. $48.09 B. $52.96 C. $54.02 D. $61.58 Price = [$648,200/(0.14 − 0.038)]/120,000 = $52.96

26.

The semi-strong form of the efficient market hypothesis states that: A. the efficient market hypothesis is only half true. B. professional investors make superior profits but amateurs can’t. C. stock prices do not follow a random walk. D. prices reflect all publicly available information. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-foundations and types

27.

If the general sentiment of investors is pessimistic, stock prices are more apt to: A. increase significantly. B. increase slightly. C. remain constant. D. decline.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Behavioral finance

28.

Which of these statements is correct? Free cash flow A. is available to be paid out to investors as interest or dividends, or to repay debt or buy back stock. B. is positive if the company is issuing debt or stock. C. is equal to net income. D. is another term for retained earnings. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-03 Apply valuation models to an entire business. Topic: Valuing an entire business

29.

If markets are efficient, when new information about a stock becomes available, the price will: A. remain unchanged because it already reflects this information. B. accurately and rapidly adjust to include this new information. C. adjust to accurately reflect this new information over the course of the next few days. D. most likely increase because all new information has a positive effect on stock prices. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street.

Topic: Market efficiency-implications

30.

Which statement is correct? A. Stock repurchases invalidate the dividend discount model B. Stock repurchases do not add value to a business and can be ignored. C. When there are repurchases, it is simpler to value a business by discounting the free cash flow. D. Stock repurchases increase the number of shares and make it difficult to forecast dividends per share AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-03 Apply valuation models to an entire business. Topic: Valuing an entire business

31.

What dividend yield would be reported in the financial press for a stock that currently pays a $1 dividend per quarter and the most recent stock price was $40? A. 2.5% B. 4.0% C. 10.0% D. 5.0% Dividend yield = ($1 × 4)/$40 = 0.100, or 10.0%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper. Topic: Stock returns and yields

32.

Which of the following values treats the firm as a going concern? A. Market value B. Book value C. Liquidation value D. Both market and book values AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper. Topic: Market and book values

33.

If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year and the dividend payout ratio is 40%, what is the stock's current price? A. $24.30 B. $18.00 C. $22.22 D. $40.50 Price = 13.5 × $3 = $40.50

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Stock valuation using multiples

34.

With respect to the notion that stock prices follow a random walk, many researchers have concluded that: A. stock prices reflect a majority of available information about the firm. B. successive price changes are predictable. C. past stock price changes provide little useful information about future stock price changes. D. stock prices always rise excessively in January. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

35.

What is the current price of a share of stock for a firm with $5 million in balance-sheet equity, 500,000 shares of stock outstanding, and a price/book value ratio of 4? A. $2.50 B. $10.00 C. $20.00 D. $40.00 Price = 4 × ($5,000,000/500,000) = $40

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Stock valuation using multiples

36.

A firm's liquidation value is the amount: A. necessary to repurchase all outstanding shares of common stock. B. realized from selling all assets and paying off all creditors. C. a purchaser would pay to acquire all of the firm's assets. D. shown on the balance sheet as total owners' equity.

37.

Which one of the following is least likely to account for an excess of market value over book value of equity? A. Inaccurate depreciation methods B. High rate of return on assets C. The presence of growth opportunities D. Valuable off-balance sheet assets

38.

Firms with valuable intangible assets are more likely to show a(n): A. excess of book value over market value of equity. B. high going-concern value. C. low liquidation value. D. low P/E ratio.

39.

Which of the following is inconsistent with a firm that sells for very near book value? A. Low current earnings B. Few, if any, intangible assets C. High future earning power D. Low, unstable dividend payment AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy

Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Market and book values

40.

A stock paying $5 in annual dividends currently sells for $80 and has an expected return of 14%. What might investors expect to pay for the stock one year from now after the next dividend has been paid? A. $82.20 B. $86.20 C. $87.20 D. $91.20 0.14 = (P1 + $5 − 80)/$80 P1 = $86.20

41.

A stock currently sells for $50 per share, has an expected return of 15%, and an expected capital appreciation rate of 10%. What is the amount of the expected dividend? A. $2.50 B. $2.75 C. $3.00 D. $3.50 Dividend yield = 0.15 − 0.10 = 0.05 Expected dividend = 0.05 × $50 = $2.50

42.

The expected return on a common stock is equal to: A. [(1 + dividend yield) × (1 + capital appreciation rate)] − 1. B. the capital appreciation rate + dividend yield. C. (1 + capital appreciation rate)/(1 + dividend yield). D. the capital appreciation rate − dividend yield.

43.

It is possible to ignore cash dividends that occur very far into the future when using a dividend discount model because those dividends: A. will most likely be paid to a different investor. B. will most likely not be paid. C. have an insignificant present value. D. have a minimal, if any, potential rate of growth.

44.

If the dividend yield for year 1 is expected to be 5% based on a stock price of $25, what will the year 4 dividend be if dividends grow annually at a constant rate of 6%? A. $1.33 B. $1.49 C. $1.58 D. $1.67 DIV4 = (0.05 × $25) × 1.063 = $1.49

45.

Dani's just paid an annual dividend of $6 per share. What is the dividend expected to be in five years if the growth rate is 4.2%? A. $7.07 B. $7.37 C. $7.14 D. $7.44 DIV3 = $6 × 1.0425 = $7.37

46.

The value of common stock will likely decrease if: A. the investment horizon decreases. B. the growth rate of dividends increases. C. the discount rate increases. D. dividends are discounted back to the present.

47.

When valuing stock with the dividend discount model, the present value of future dividends will: A. change depending on the time horizon selected. B. remain constant regardless of the time horizon selected. C. remain constant regardless of the rate of growth. D. always equal the present value of the terminal price.

48.

What should be the price for a common stock paying $3.50 annually in dividends if the growth rate is zero and the discount rate is 8%? A. $22.86 B. $28.00 C. $42.00 D. $43.75 Price = $3.50/0.08 = $43.75

49.

What should you pay for a stock if next year's annual dividend is forecast to be $5.25, the constant-growth rate is 2.85%, and you require a 15.5% rate of return? A. $31.25 B. $38.87 C. $41.50 D. $42.68 Price = $5.25/(0.155 − 0.0285) = $41.50

50.

What price would you pay today for a stock if you require a rate of return of 13%, the dividend growth rate is 3.6%, and the firm recently paid an annual dividend of $2.50? A. $27.55 B. $30.28 C. $26.60 D. $31.37 Price = ($2.50 × 1.036)/(0.13 − 0.036) = $27.55

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios.

Topic: Constant-growth stock

51.

What constant-growth rate in dividends is expected for a stock valued at $32.40 if next year's dividend is forecast at $2.20 and the appropriate discount rate is 13.6%? A. 7.02% B. 6.59% C. 6.81% D. 7.38% $32.40 = $2.20/(0.136 − g); g = 0.0681, or 6.81%

52.

What rate of return is expected from a stock that sells for $30 per share, pays $1.54 annually in dividends, and is expected to sell for $32.80 per share in one year? A. 15.03% B. 14.28% C. 14.09% D. 14.47% Expected return = ($32.80 + 1.54 − 30)/$30 = 0.1447, or 14.47%

53.

ABC common stock is expected to have extraordinary growth in earnings and dividends of 20% per year for 2 years, after which the growth rate will settle into a constant 6%. If the discount rate is 15% and the most recent dividend was $2.50, what should be the approximate current share price? A. $31.16 B. $33.23 C. $37.39 D. $47.77 Price = ($2.50 × 1.2)/1.15 + ($2.50 × 1.22)/1.152 + [($2.50 × 1.22 ×1.06)/(0.15 − 0.06)]/1.152 = $37.39

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard

54.

What would be the approximate expected price of a stock when dividends are expected to grow at a 25% rate in each of years 2 and 3, and then grow at a constant rate of 5% if the stock's required return is 13% and next year's dividend will be $4.00? A. $67.60 B. $62.08 C. $68.64 D. $73.44 Price = $4/1.13 + ($4 × 1.25)/1.132 + ($4 × 1.252)/1.133 + [($4 × 1.252 ×1.05)/(0.13 − 0.05)]/1.133 = $68.64

55.

A company with a return on equity of 15% and a plowback ratio of 60% would expect a constant-growth rate of: A. 4%. B. 9%. C. 21%. D. 25%. g = 0.15 × 0.60 = 0.09, or 9%

56.

What is the plowback ratio for a firm that has earnings per share of $2.68 and pays out $1.75 per share in dividends? A. 28.20% B. 34.70% C. 66.67% D. 71.80% Plowback ratio = ($2.68 − 1.75)/$2.68 = 0.3470, or 34.70%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze

Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Constant-growth stock

57.

A positive value for PVGO suggests that the firm has: A. a positive return on equity. B. a positive plowback ratio. C. investment opportunities with superior returns. D. a high rate of constant growth.

58.

Which of the following situations accurately describes a growth stock, assuming that each firm has a required return of 12%? A. A firm with PVGO = $0. B. A firm with investment opportunities yielding 10%. C. A firm with investment opportunities yielding 15%. D. A firm with PVGO < $0.

59.

Other things equal, a firm's sustainable growth rate could increase as a result of: A. increasing the plowback ratio. B. increasing the payout ratio. C. decreasing the return on equity. D. increasing total assets.

60.

Under which of the following forms of market efficiency would stock prices always reflect fair value? A. Weak-form efficiency B. Semi-strong-form efficiency C. Strong-form efficiency D. Semi-weak-form efficiency AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

61.

Investors are willing to purchase stocks having high P/E ratios because: A. they expect these shares to sell for a lower price. B. they expect these shares to offer higher dividend payments. C. these shares are accompanied by guaranteed earnings. D. they expect these shares to have greater growth opportunities.

62.

Which of the following is least likely to contribute to going concern value? A. High liquidation value B. Extra earning power C. Future investment opportunities D. Intangible assets

63.

What happens to a firm that reinvests its earnings at a rate equal to the firm's required return? A. Its stock price will remain constant. B. Its stock price will increase by the sustainable growth rate. C. Its stock price will decline unless the dividend payout ratio is zero. D. Its stock price will decline unless the plowback rate exceeds the required return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Net present value growth opportunity

64.

What can be expected to happen when stocks having the same expected risk do not have the same expected return? A. At least one of the stocks becomes temporarily mispriced. B. This is a common occurrence indicating that one stock has more PVGO. C. This cannot happen if the shares are traded in an auction market. D. The expected risk levels will change until the expected returns are equal.

65.

The terminal value of a share of stock: A. is similar to the maturity value of a bond. B. refers to the share value at the end of an investor's holding period. C. is the value received by investors upon liquidation of the firm. D. is the price for shares traded through a dealers' market.

AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios. Topic: Dividend discount model

66.

A stock is expected to pay dividends of $1.20 per share in Year 1 and $1.35 per share in Year 2. After that, the dividend is expected to increase by 2.5% annually. What is the current value of the stock at a discount rate of 14.5%? A. $11.29 B. $10.87 C. $12.07 D. $13.39 Price = $1.20/1.145 + $1.35/1.1452 + [($1.35 × 1.025)/(0.145 − 0.025)]/1.1452 = $10.87

67.

Jefferson's recently paid an annual dividend of $1.31 per share. The dividend is expected to decrease by 4% each year. How much should you pay for this stock today if your required return is 16%? A. $6.29 B. $5.74 C. $10.48 D. $11.57 Price = [$1.31 × (1 − 0.04)]/[0.16 − (−0.04)] = $6.29

68.

Which one of the following is more likely to be responsible for a firm having a low PVGO? A. ROE exceeds required return. B. Plowback is very high. C. Market value of equity is close to book value. D. Book value of equity is low.

69.

What is the most likely value of the PVGO for a stock with a current price of $50, expected earnings of $6 per share, and a required return of 20%? A. $10 B. $20 C. $25 D. $30 With a 100% payout ratio, the stock would be valued at $30 ($6/0.20 = $30). Thus, the $20 of additional price must represent the PVGO.

70.

What is the expected constant-growth rate of dividends for a stock with a current price of $87, an expected dividend payment of $5.40 per share, and a required return of 16%? A. 8.48% B. 6.25% C. 9.79% D. 5.23% $87 = $5.40/(0.16 − g); g = 0.0979, or 9.79%

71.

Which of the following is true for a firm having a stock price of $42, an expected dividend of $3, and a sustainable growth rate of 8%? A. It has a required return of 15.14%. B. It has a dividend yield of 7.35%. C. The stock price is expected to be $45 next year. D. It has a capital appreciation rate of 7.14%. Required return = $3/$42 + 0.08 = 0.1514, or 15.14%

72.

What is the value of the expected dividend per share for a stock that has a required return of 16%, a price of $45, and a constant-growth rate of 12%? A. $1.80 B. $3.60 C. $4.50 D. $7.20 $45 = DIV1/(0.16 − 0.12); Div1 = $1.80

Topic: Constant-growth stock

73.

What is the required return for a stock that has a constant-growth rate of 3.3%, a price of $25, an expected dividend of $2.10, and a P/E ratio of 14.4? A. 12.40% B. 10.92% C. 11.70% D. 11.26% $25 = $2.10/(r − 0.033); r = 11.70%

74.

What should be the price of a stock that offers a $4.32 annual dividend with no prospects of growth, and has a required return of 12.5%? A. $0 B. $4.86 C. $34.56 D. $30.24 P = $4.32/0.125 = $34.56

75.

Psychologists have observed that: A. once investors have made a loss, they become much more willing to take risks. B. investors tend to place too much faith in their ability to spot mispriced stocks. C. when forecasting the future, people tend to place too little weight on recent events. D. investors like stocks of companies whose names begin with letters that occur early in the alphabet. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Behavioral finance

76.

If The Wall Street Journal lists a stock's dividend as $1, then it is most likely the case that the stock: A. pays $1 per share per quarter. B. paid $.25 per share per quarter for the past year. C. paid $1 during the past quarter, with no future dividends forecast. D. is expected to pay a dividend of $1 per share at the end of next year. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper. Topic: Common stock features

77.

Suzi owns 100 shares of AB stock. She expects to receive a $238 in dividends next year. Investors expect the stock to sell for $46 a share one year from now. What is the intrinsic value of this stock if the dividend payout ratio is 40% and the discount rate is 13.5%? A. $38.19 B. $42.63 C. $40.53 D. $45.77 Intrinsic value = [($238/100) + $46]/1.135 = $42.63

78.

What is the minimum amount shareholders should expect to receive in the event of a complete corporate liquidation? A. Market value of equity B. Book value of equity C. Zero D. Shareholders may be required to pay to be liquidated.

79.

If the price of a stock falls on 4 consecutive days of trading, then stock prices: A. cannot be following a random walk. B. can still be following a random walk. C. are almost certain to increase the following day. D. are almost certain to decrease the following day. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

80.

What should be the stock value one year from today for a stock that currently sells for $35, has a required return of 15%, an expected dividend of $2.80, and a constant dividend growth rate of 7%? A. $37.45 B. $37.80 C. $40.25 D. $43.05 $2.80 × 1.07/(0.15 − 0.07) = $37.45

81.

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

82.

What should be the current price of a share of stock if a $5 dividend was just paid, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A. $19.23 B. $25.00 C. $35.71 D. $37.86 Price = ($5 × 1.06)/(0.20 − 0.06) = $37.86

83.

What should be the current price of a stock if the expected dividend is $5, the stock has a required return of 20%, and a constant dividend growth rate of 6%? A. $19.23 B. $25.00 C. $35.71 D. $37.86 Price = $5.00/(0.20 − 0.06) = $35.71

84.

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

85.

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

86.

How much of a stock's $30 price is reflected in PVGO if it expects to earn $4 per share, has an expected dividend of $2.50, and a required return of 20%? A. $0 B. $6 C. $8 D. $10 PVGO = $30 − ($4/0.2) = $10

87.

What is the expected constant-growth rate of dividends for a stock currently priced at $50, that just paid a dividend of $4, and has a required return of 18%? A. 3.41% B. 5.50% C. 9.26% D. 12.5% $50 = $4(1 + g)/(0.18 - g); g = 9.26%

Topic: Constant-growth stock

88.

According to random-walk theory, what are the (approximate) odds that a stock will increase in price after having increased on two consecutive days of trading? A. 0% B. 25% C. 50% D. 100% AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

89.

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

90.

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

91.

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

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

92.

Based on the random walk theory, if a stock's price decreased last week, then this week the price: A. will reverse last week's loss and go up. B. will continue last week's decline. C. will stand still until new information is released. D. has an equal chance of going either up or down. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

93.

Research indicates that the correlation coefficient between successive days' stock price changes is: A. quite close to +1. B. quite close to C. quite close to zero. D. directly related to the stock's beta. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

94.

An analyst who relies on past cycles of stock pricing to make investment decisions is: A. performing fundamental analysis. B. relying on strong-form market efficiency. C. assuming that the market is not even weak-form efficient. D. relying on the random walk of stock prices. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Random walk

95.

Which statement is correct? A. When stock prices barely change for a while, they are said to be stuck in a "bubble." B. Bubbles can result when prices rise rapidly and investors join the game on the assumption that prices will continue to rise. C. Most bubbles with hindsight can be justified by the improved fundamentals. D. "Bubbles" is another term for stocks in high-tech industries. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Behavioral finance

96.

If it proves possible to make abnormal profits based on information regarding past stock prices, then the market is: A. weak-form efficient. B. not weak-form efficient. C. semi strong-form efficient. D. strong-form efficient. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

97.

Which statement is correct? A. The momentum factor refers to the tendency for stock price changes to reverse. B. The momentum factor refers to the tendency for stock price changes to persist for a while and then revert. C. The momentum factor implies that stock prices are rather like a pendulum. D. The momentum factor is inconsistent with the strong form of the efficient market hypothesis. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street.

98.

Which statement is correct? A. It is much easier to judge whether the absolute level of stock prices is correct rather than whether their relative levels are correct. B. It is much easier to judge whether relative stock prices are correct than to judge whether their absolute level is correct. C. Most tests of market efficiency are concerned with the absolute level of stock prices. D. If relative prices are correct, then absolute prices must be correct also. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-foundations and types

99.

Market efficiency implies A. that investors are irrational. B. that there is no point to buying common stocks. C. that consistently superior performance is very difficult even for professional investors. D. that there are no taxes. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

100.

If no price change occurs in a stock on the day that it announces its next dividend, it can be assumed that: A. the stock market is inefficient. B. the dividend was reduced. C. the market was expecting this information. D. technical analysts are not following this stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

101.

When investors are not capable of making superior investment decisions on a consistent basis based on past prices or public or private information, the market is said to be: A. weak-form efficient. B. semi strong-form efficient. C. strong-form efficient. D. fundamentally efficient. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-foundations and types

102.

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

Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

103.

For corporate financial managers an important lesson of market efficiency is: A. Trust market prices unless you have a clear advantage that ensures the odds are in your favor. B. Issue stock after a rise in price. C. Be on the lookout for undervalued companies to take over. D. Your company should be able to make healthy profits from its foreign exchange dealings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

104.

When new information becomes available in the market, evidence generally suggests that: A. insiders will be the only investors to gain. B. it takes at least ten trading days for stock prices to adjust. C. stock prices will adjust to the information rapidly. D. transaction costs will erase any benefit of trading on the information. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-studies and challenges

105.

Suppose that the total value of dividends to be paid by companies in the Narnian stock market index is $100 billion. Investors expect dividends to grow over the long term by 5% annually, and they require a 10% return. Now a collapse in the economy leads investors to revise their growth estimate down to 4%. By how much should market values change? A. −16.67%. B. zero. C. −20%. D. +20%. Before the collapse: PV = 100/(0.10 − 0.05) = $2,000 bn After the collapse: PV = 100/(0.10 − 0.04) =$1,667 bn Change = 1,667/2,000 − 1 = −16.67%

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

106.

Your broker suggests that you can make consistent, excess profits by purchasing stocks on the 20 th of the month and selling them on the last day of the month. If this is true, then: A. the market is only semi strong-form efficient. B. the market violates even weak-form efficiency. C. insiders will be the only investors to profit. D. prices follow a random walk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

107.

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

108.

The statement that there are no free lunches on Wall Street suggests that: A. the market is strong-form efficient. B. there is no return to technical or fundamental analysis. C. security prices reflect all available information. D. food stocks offer the lowest rates of return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street. Topic: Market efficiency-implications

Chapter 07 Test Bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

108

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

108

Learning Objective: 07-01 Understand the stock trading reports on the Internet or in the financial pages of the newspaper.

Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and show how growth opportunities are reflected in stock prices and price-earnings ratios.

Learning Objective: 07-03 Apply valuation models to an entire business.

Learning Objective: 07-04 Understand what professionals mean when they say that there are no free lunches on Wall Street.

Topic: Behavioral finance

Topic: Common stock features

Topic: Constant-growth stock

Topic: Dividend discount model

Topic: Internal and sustainable growth rates

Topic: Market and book values

Topic: Market efficiency-foundations and types

Topic: Market efficiency-implications

Topic: Market efficiency-studies and challenges

Topic: Net present value growth opportunity

Topic: Nonconstant-growth stock

Topic: Perpetuities

Topic: Random walk

Topic: Risk and return relationship

Topic: Stock returns and yields

Topic: Stock valuation using multiples

Topic: Two-stage growth stock

Topic: Valuing an entire business

Chapter 08 Test bank - Static Student: ___________________________________________________________________________

As the opportunity cost of capital decreases, the net present value of a project increases. True

The IRR is the rate of return on the cash flows of the investment, also known as the opportunity cost of capital. True

False

A project's payback period is the length of time necessary to generate an NPV of zero. True

False

When using a profitability index to select projects, a high value is preferred over a low value. True

False

For mutually exclusive projects, the project with the higher IRR is the correct selection. True

False

Unlike using IRR, selecting projects according to their NPV will always lead to a correct accept-reject decision. True

False

When calculating IRR with a trial and error process, discount rates should usually be raised when NPV is positive. True

False

Projects with an NPV of zero decrease shareholders' wealth by the cost of the project. True

False

The payback period considers all project cash flows. True

False

10. Both the NPV and the internal rate of return methods recognize that the timing of cash flows affects project value. True

False

11. If a project has multiple IRRs, the lowest one is incorrect. True

False

12. Because of deficiencies associated with the payback method, it is seldom used in corporate financial analysis today. True

False

13. A risky dollar is worth more than a safe one. True

False

14. When choosing among mutually exclusive projects with similar lives, the choice is easy using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV. True

False

15. When we compare assets with different lives, we should select the machine that has the lowest equivalent annual cost. True

False

16. For many firms the limits on capital funds are "soft." By this we mean that the capital rationing is not imposed by investors. True

False

17. Soft rationing should never cost the firm anything. True

False

18. For most managers, discounted cash-flow analysis is in fact the dominant tool for project evaluation. True

False

19. The payback rule states that a project is acceptable if you get your money back within a specified period. True

False

20. The payback rule always makes shareholders better off. True

False

21. When you have to choose between projects with different lives, you should put them on an equal footing by computing the equivalent annual annuity or benefit of the two projects. True

False

22. When you are considering whether to replace an aging machine with a new one, you should compare the equivalent annual cost of operating the old one with the equivalent annual cost of the new one. True

False

23. A project's opportunity cost of capital is: A. the return that shareholders could expect to earn by investing in the financial markets. B. the return earned by investing in the project. C. equal to the average return on all company projects. D. designed to be less than the project's IRR.

24. Which one of the following statements is correct for a project with a positive NPV? A. The IRR must be greater than 0. B. Accepting the project has an indeterminate effect on shareholders. C. The discount rate exceeds the cost of capital. D. The profitability index equals 1. 25. If the net present value of a project that costs $20,000 is $5,000 when the discount rate is 10%, then the: A. project's IRR equals 10%. B. project's rate of return is greater than 10%. C. net present value of the cash inflows is $4,500. D. project's cash inflows total $25,000. 26. What is the NPV of a project that costs $100,000 and returns $50,000 annually for 3 years if the opportunity cost of capital is 14%? A. $13,397.57 B. $14,473.44 C. $16,081.60 D. $33,748.58 27. The decision rule for net present value is to: A. accept all projects with cash inflows exceeding the initial cost. B. reject all projects with rates of return exceeding the opportunity cost of capital. C. accept all projects with positive net present values. D. reject all projects lasting longer than 10 years. 28. If a project’s NPV is calculated to be negative what should a project manner do? A. The discount rate should be decreased. B. The profitability index should be calculated. C. The present value of the project cost should be determined. D. The project should be rejected. 29. Which one of the following changes will increase the NPV of a project? A. A decrease in the discount rate B. A decrease in the size of the cash inflows C. An increase in the initial cost of the project D. A decrease in the number of cash inflows 30. What is the maximum that should be invested in a project at time zero if the inflows are estimated at $50,000 annually for 3 years, and the cost of capital is 9%? A. $101,251.79 B. $109,200.00 C. $126,564.73 D. $130,800.00

31. When a manager does not accept a positive-NPV project, shareholders face an opportunity cost in the amount of the: A. project's initial cost. B. project's NPV. C. project's discounted cash inflows. D. soft capital rationing budget. 32. What is the maximum amount a firm should pay for a project that will return $15,000 annually for 5 years if the opportunity cost is 10%? A. $24,157.65 B. $56,861.80 C. $62,540.10 D. $48,021.19 33. Which of the following projects would you feel safest in accepting? Assume the opportunity cost of capital to be 12% for each project. A. "A" has a small, but negative, NPV. B. "B" has a positive NPV when discounted at 10%. C. "C's" cost of capital exceeds its rate of return. D. "D" has a zero NPV when discounted at 14%. 34. As the discount rate is increased, the NPV of a specific project will: A. increase. B. decrease. C. remain constant. D. decrease to zero, then remain constant. 35. A project requires an initial outlay of $10 million. If the cost of capital exceeds the project IRR, then the project has a(n): A. positive NPV. B. negative NPV. C. acceptable payback period. D. positive profitability index. 36. The modified internal rate of return can be used to correct for: A. negative NPV calculations. B. multiple internal rates of return. C. undefined payback periods. D. borrowing projects. 37. The internal rate of return is most reliable when evaluating: A. a single project with alternating cash inflows and outflows over several years. B. mutually exclusive projects of differing sizes. C. a single project with only cash inflows following the initial cash outflow. D. a single project with cash outflows at time 0 and the final year and inflows in all other time periods.

38. When a project's internal rate of return equals its opportunity cost of capital, then the: A. project should be rejected. B. project has no cash inflows. C. net present value will be positive. D. net present value will be zero. 39. Firms that make investment decisions based on the payback rule may be biased toward rejecting projects: A. with short lives. B. with long lives. C. with late cash inflows. D. that have negative NPVs. 40. One way to increase the NPV of a project is to decrease the: A. project's payback period. B. profitability index. C. time until the receipt of cash inflows. D. number of project IRRs. 41. What is the IRR for a project that costs $100,000 and provides annual cash inflows of $30,000 for 6 years starting one year from today? A. 19.91% B. 16.67% C. 15.84% D. 22.09% 42. What is the IRR of a project that costs $100,000 and provides cash inflows of $17,000 annually for 6 years? A. 0.57% B. 1.21% C. 5.69% D. 12.10% 43. An investment costs $100,000 and provides a cash inflow of $17,000 per year. If the discount rate is 13%, how long must the cash inflows last for it to be an acceptable investment? A. 24 years B. 6 years C. 10 years D. 12 years 44. If a project costs $72,000 and returns $18,500 per year for 5 years, what is its IRR? A. 8.98% B. 7.39% C. 8.50% D. 7.67%

45. If the IRR for a project is 15%, then the project's NPV would be: A. negative at a discount rate of 10%. B. positive at a discount rate of 20%. C. negative at a discount rate of 20%. D. positive at a discount rate of 15%. 46. As long as the NPV of a project declines smoothly with increases in the discount rate, the project is acceptable if its: A. internal rate of return is positive. B. payback period is greater than one. C. rate of return exceeds the cost of capital. D. cash inflows equal the initial cost. 47. A project can have as many different internal rates of return as it has: A. cash inflows. B. cash outflows. C. periods of cash flow. D. changes in the sign of the cash flows. 48. What is the NPV for the following project cash flows at a discount rate of 15%? C0 = −$1,000, C1 = $700, C2 = $700. A. ($308.70) B. ($138.00) C. $138.00 D. $308.70 49. What is the IRR of a project with the following cash flows: C0 = −$200, C1 = $ 110, C2 = $121? A. Zero B. 10% C. 18% D. 5% 50. A project costing $20,000 generates cash inflows of $9,000 annually for the first 3 years, followed by cash outflows of $1,000 annually for 2 years. At most, this project has ______ different IRR(s). A. one B. two C. three D. five 51. How many IRRs are possible for the following set of cash flows? CF0 = −$1,000, C1 = $500, C2 = −$300, C3 = $1,000, C4 = $200. A. One B. Two C. Three D. Four

52. Given a particular set of project cash flows, which one of the following statements must be correct? A. There can be only one NPV for the project. B. There can be only one IRR for the project. C. There can be more than one IRR for the project. D. There can be up to two profitability indexes for any project. 53. When projects are mutually exclusive, you should choose the project with the: A. longer life. B. larger initial size. C. highest IRR. D. highest NPV. 54. When managers select correctly from among mutually exclusive projects, they: A. may give up rate of return for NPV. B. may give up NPV for rate of return. C. have a tendency to select the largest project. D. focus on the payback method to avoid conflicting signals. 55. When evaluating mutually exclusive projects, remember: A. the project with the higher IRR may have the higher NPV at one discount rate and a lower NPV at another . B. cash flows cannot be discounted when considering mutually exclusive projects. C. mutually exclusive projects produce negative IRR values. D. mutually exclusive projects always have multiple IRRs. 56. Two mutually exclusive projects have the same IRR. When will you be indifferent between them? A. When the IRR is equal to the cost of capital. B. Always if they have the same IRR. C. When the IRR is less than the cost of capital. D. When there is only one change in the sign of the cash flows. 57. When managers cannot determine whether to invest now or wait until costs decrease later, the rule should be to: A. postpone until costs reach their lowest level. B. invest now to maximize the NPV. C. postpone until the opportunity cost reaches its lowest level. D. invest at the date that provides the highest NPV today. 58. You are analyzing a project that is equivalent to borrowing money. This project's: A. NPV graph rises as discount rates decrease. B. initial cash flow is an outflow of funds. C. value increases when the cost of capital increases. D. acceptance requires its IRR to exceed the cost of capital.

59. If two machines produce the same product but have different lives, you should choose the machine with the: A. highest IRR. B. longest life. C. lowest equivalent annual cost. D. highest NPV, discounted at the opportunity cost of capital. 60. Which mutually exclusive project would you select, if both are priced at $1,000 and your required return is 15%: Project A with three annual cash flows of $1,000; or Project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? A. Project A B. Project B C. You are indifferent since the NPVs are equal. D. Neither project should be selected. 61. What is the possible cost of capital rationing? A. The firm may have excess fixed assets. B. The firm is likely to take too many risky projects. C. The firm may miss out on positive NPV opportunities D. The firm may have too high a cost of capital. 62. Soft capital rationing: A. is costly to shareholders. B. is used to evaluate mutually exclusive projects. C. should be costless to the shareholders of the firm. D. solves the problem of investment timing. 63. Soft capital rationing is imposed upon a firm by _____, while hard capital rationing is imposed by _____. A. management; the capital market. B. the capital market; management. C. the government; the capital market. D. the capital market; the government. 64. If a project has a cost of $50,000 and a profitability index of 2, then: A. it has a negative NPV. B. its NPV could be positive or negative depending on the cost of capital. C. its cash flow is $100,000. D. it has a positive NPV. 65. In simple cases when hard capital rationing exists, projects may be evaluated by : A. the payback period. B. mutually exclusive IRRs. C. a profitability index. D. the modified internal rate of return.

66. Use of a profitability index to evaluate mutually exclusive projects in the absence of capital rationing: A. will provide the same rankings as an NPV criterion. B. will maximize NPV, but not IRR. C. can result in misguided selections. D. is technically impossible. 67. The profitability index selects projects based on the: A. highest net discounted value at time zero. B. highest internal rate of return. C. largest dollar investment per rate of return. D. largest return per dollar invested. 68. Which of the following investment criteria takes the time value of money into consideration? A. Net present value only B. Profitability index and net present value only C. Internal rate of return and net present value only D. Profitability index, internal rate of return, and net present value 69. When calculating a project's payback period, cash flows are: A. discounted at the opportunity cost of capital. B. discounted at the internal rate of return. C. discounted at the risk-free rate of return. D. not discounted at all. 70. What is the profitability index for a project costing $40,000 and returning $15,000 annually for 4 years at an opportunity cost of capital of 12%? A. 0.139 B. 0.320 C. 0.500 D. 0.861 71. Which of the following statements is true for a project with a $20,000 initial cost, cash inflows of $6,667 per year for 6 years, and a discount rate of 15%? A. Its payback period is 3 years. B. Its NPV is $2,094. C. Its IRR is 17.85%. D. Its profitability index is 0.104. 72. The "gold standard" of investment criteria refers to the: A. net present value rule. B. internal rate of return rule. C. payback rule. D. profitability index rule.

73. Which of the following investment decision rules tends to improperly reject long-lived projects? A. Net present value B. Internal rate of return C. Payback period D. Profitability index 74. The ratio of net present value to initial investment is known as the: A. net present value. B. internal rate of return. C. payback period. D. profitability index. 75. For mutually exclusive projects, the IRR can be used to select the best project: A. by calculating the modified internal rate of return. B. by calculating the IRR based on incremental cash flows. C. by using the discount rate to calculate the IRR. D. never. IRR cannot be utilized for mutually exclusive projects. 76. The opportunity cost of capital is equal to: A. the discount rate that makes the project NPV equal zero. B. the return that shareholders could expect by investing their money in the financial markets. C. a project's internal rate of return. D. the average rate of return for a firm's projects. 77. Occasionally projects may have positive initial cash flows. Such projects: A. are like lending money. B. are like borrowing money. C. have no IRR. D. their IRR increases as the cost of capital increases. 78. A project with an IRR that is less than the opportunity cost of capital should be: A. accepted for all projects. B. accepted only for projects with a positive initial cash flow. C. accepted only for projects with a negative initial cash flow. D. rejected for all projects. 79. If a project's expected rate of return exceeds its opportunity cost of capital, one would expect: A. the profitability index to be negative. B. the opportunity cost of capital to be too low. C. the project to have a positive NPV. D. the NPV to be zero.

80. Which one of the following should be assumed about a project that requires a $100,000 investment at time zero, then returns $20,000 annually for 5 years? A. The NPV is negative. B. The NPV is zero. C. The profitability index is 1.0. D. The IRR is negative. 81. If two projects offer the same positive NPV, then they: A. also have the same IRR. B. have the same payback period. C. are mutually exclusive projects. D. add the same amount of value to the firm. 82. What is the minimum cash flow that could be received at the end of year 3 to make the following project "acceptable"? Initial cost = $100,000; cash flows at end of years 1 and 2 = $35,000; opportunity cost of capital = 10%. A. $29,494 B. $30,000 C. $39,256 D. $52,250 83. According to the NPV rule, all projects should be accepted if NPV is positive when discounted at the: A. internal rate of return. B. opportunity cost of capital. C. risk-free interest rate. D. accounting rate of return. 84. If a project's IRR is 13% and the project provides annual cash flows of $15,000 for 4 years, how much did the project cost? A. $44,617.07 B. $52,208.18 C. $41,909.29 D. $49,082.11 85. A project's payback period is determined to be 4 years. If it is later discovered that additional cash flows will be generated in years 5 and 6, then the project's payback period will: A. be reduced. B. be increased. C. be unchanged. D. change but the discount rate must be known to determine the nature of the change. 86. A polisher costs $10,000 and will cost $20,000 a year to operate and maintain. If the discount rate is 10% and the polisher will last for 5 years, what is the equivalent annual cost of the tool? A. $17,163.04 B. $22,187.84 C. $22,637.98 D. $19,411.15

87. Selecting the project(s) with the highest NPV(s) is not the correct decision rule when: A. there is capital rationing. B. there are mutually exclusive projects. C. projects are long-lived. D. projects are independent. 88. The investment timing problem arises when: A. cash flows may occur at the beginning or end of each time period. B. there is a choice between using the payback or NPV rules. C. the project has a positive initial cash flow. D. investment can occur now or at some future point. 89. A company owns a tract of timber that will keep growing for a number of years. It calculates that the timber’s value less the cost of harvesting is currently $50,000 and that this figure will grow by 10% in the next year and by 5% in the following year. If the cost of capital is 8%, when should the company harvest the timber? A. today. B. year 1. C. year 2. D. harvest a third of the timber each year. 90. To justify postponing a project for one year, the NPV needs to increase over that year by a rate that is equal to or greater than: A. the project's IRR. B. the risk-free rate. C. the cost of capital. D. zero. 91. What happens to the equivalent annual cost of a project as the opportunity cost of capital decreases? A. It increases. B. It decreases. C. It is not affected. D. It depends on whether or not the projects are mutually exclusive. 92. What is the equivalent annual cost for a project that requires a $40,000 investment at time zero, and a $10,000 annual expense during each of the next 4 years, if the opportunity cost of capital is 10%? A. $20,000.00 B. $21,356.95 C. $22,618.83 D. $25,237.66 93. A currently used machine costs $10,000 annually to run. What is the maximum that should be paid to replace the machine with one that will last 3 years and cost only $4,000 annually to run? The opportunity cost of capital is 12%. A. $15,209.84 B. $9,607.33 C. $14,410.99 D. $10,338.56

94. Because of its age, your car costs $4,000 annually in maintenance expense. You could replace it with a newer vehicle costing $8,000. Both vehicles would be expected to last 4 more years, at which point they will be valueless. If your opportunity cost is 8%, by how much must maintenance expense decrease on the newer vehicle to justify its purchase? A. $1,625.40 B. $1,584.63 C. $1,469.08 D. $1,409.54 95. Projects A and B are mutually exclusive lending projects. Project A has an IRR of 20% while Project B has an IRR of 30%. You would be more likely to choose B unless: A. Project B has a longer life than Project A. B. Project A has more risk than Project B. C. Project A is twice the size of Project B. D. Project B has a larger cash inflow in Year 1 than Project A. 96. What is the decision rule in the case of sign changes that produce multiple IRRs for a project? A. Select the lowest IRR to be conservative B. Select the highest IRR to maximize the benefits C. Any or all of the IRRs are justified to use D. Calculate the modified internal rate of return. 97. If a project has a payback period of 5 years and a cost of capital of 10%, then the discounted payback will: A. exceed 5 years. B. be less than 5 years. C. decrease if the cost of capital increases. D. decrease if the payback period increases due to revised cash flows. 98. You can continue to use your less efficient machine at a cost of $8,000 annually. Alternatively, you can purchase a more efficient machine for $12,000 plus $5,000 annual maintenance. If the new machine lasts 5 years and the cost of capital is 15%, you should: A. buy the new machine and save $600 in equivalent annual costs. B. buy the new machine and save $388 in equivalent annual costs. C. keep the old machine and save $388 in equivalent annual costs. D. keep the old machine and save $580 in equivalent annual costs. 99. A firm is considering a project with the following cash flows: Time 0 = +$20,000, Years 1-5 = −$4,500. Should the project be accepted if the cost of capital is 10%? A. Yes; The IRR of the project is 4.06%. B. Yes; The IRR of the project is 12.5%. C. No; The IRR of the project is 4.06%. D. No; The IRR of the project is 12.5%.

100. A firm plans to use the profitability index to select between two mutually exclusive investments. If no capital rationing has been imposed, which project should be selected? A. Select the project with the higher profitability index B. Select the project with the lower profitability index C. Without capital rationing, both projects can be selected D. Without capital rationing, the NPV method must be used instead

Chapter 08 Test bank - Static Key 1.

As the opportunity cost of capital decreases, the net present value of a project increases. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

The IRR is the rate of return on the cash flows of the investment, also known as the opportunity cost of capital. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

Projects with an NPV of zero decrease shareholders' wealth by the cost of the project. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

When calculating IRR with a trial and error process, discount rates should usually be raised when NPV is positive. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

Unlike using IRR, selecting projects according to their NPV will always lead to a correct accept-reject decision. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

For mutually exclusive projects, the project with the higher IRR is the correct selection. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Mutually exclusive projects

When using a profitability index to select projects, a high value is preferred over a low value. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

A project's payback period is the length of time necessary to generate an NPV of zero. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

The payback period considers all project cash flows. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

10.

Both the NPV and the internal rate of return methods recognize that the timing of cash flows affects project value. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

11.

If a project has multiple IRRs, the lowest one is incorrect. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

12.

Because of deficiencies associated with the payback method, it is seldom used in corporate financial analysis today. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

13.

A risky dollar is worth more than a safe one. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

14.

When choosing among mutually exclusive projects with similar lives, the choice is easy using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Mutually exclusive projects

15.

When we compare assets with different lives, we should select the machine that has the lowest equivalent annual cost. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

16.

For many firms the limits on capital funds are "soft." By this we mean that the capital rationing is not imposed by investors. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Capital rationing

17.

Soft rationing should never cost the firm anything. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Capital rationing

18.

For most managers, discounted cash-flow analysis is in fact the dominant tool for project evaluation. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

19.

The payback rule states that a project is acceptable if you get your money back within a specified period. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

20.

The payback rule always makes shareholders better off. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

21.

When you have to choose between projects with different lives, you should put them on an equal footing by computing the equivalent annual annuity or benefit of the two projects. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

22.

When you are considering whether to replace an aging machine with a new one, you should compare the equivalent annual cost of operating the old one with the equivalent annual cost of the new one. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

23.

A project's opportunity cost of capital is: A. the return that shareholders could expect to earn by investing in the financial markets. B. the return earned by investing in the project. C. equal to the average return on all company projects. D. designed to be less than the project's IRR. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

24.

Which one of the following statements is correct for a project with a positive NPV? A. The IRR must be greater than 0. B. Accepting the project has an indeterminate effect on shareholders. C. The discount rate exceeds the cost of capital. D. The profitability index equals 1. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

25.

If the net present value of a project that costs $20,000 is $5,000 when the discount rate is 10%, then the: A. project's IRR equals 10%. B. project's rate of return is greater than 10%. C. net present value of the cash inflows is $4,500. D. project's cash inflows total $25,000. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

26.

What is the NPV of a project that costs $100,000 and returns $50,000 annually for 3 years if the opportunity cost of capital is 14%? A. $13,397.57 B. $14,473.44 C. $16,081.60 D. $33,748.58 NPV = −$100,000 + $50,000[(1 / 0.14) − 1 / 0.14(1.14) 3] = $16,081.60

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

27.

The decision rule for net present value is to: A. accept all projects with cash inflows exceeding the initial cost. B. reject all projects with rates of return exceeding the opportunity cost of capital. C. accept all projects with positive net present values. D. reject all projects lasting longer than 10 years. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

28.

If a project’s NPV is calculated to be negative what should a project manner do? A. The discount rate should be decreased. B. The profitability index should be calculated. C. The present value of the project cost should be determined. D. The project should be rejected. AACSB: Communication Accessibility: Keyboard Navigation

Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

29.

Which one of the following changes will increase the NPV of a project? A. A decrease in the discount rate B. A decrease in the size of the cash inflows C. An increase in the initial cost of the project D. A decrease in the number of cash inflows AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

30.

What is the maximum that should be invested in a project at time zero if the inflows are estimated at $50,000 annually for 3 years, and the cost of capital is 9%? A. $101,251.79 B. $109,200.00 C. $126,564.73 D. $130,800.00 The maximum investment would equate CF0 with the present value of the inflows thereby producing a zero net present value. CF0 = $50,000(1 / 0.09) − [1 / 0.09(1.09)3] = $126,564.73

31.

When a manager does not accept a positive-NPV project, shareholders face an opportunity cost in the amount of the: A. project's initial cost. B. project's NPV. C. project's discounted cash inflows. D. soft capital rationing budget. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project.

Topic: Net present value

32.

What is the maximum amount a firm should pay for a project that will return $15,000 annually for 5 years if the opportunity cost is 10%? A. $24,157.65 B. $56,861.80 C. $62,540.10 D. $48,021.19 The maximum investment would equate CF0 with the present value of the inflows thereby producing a zero net present value. CF0 = $15,000(1 / 0.10) − [1 / 0.10(1.10)5] = $56,861.80

33.

Which of the following projects would you feel safest in accepting? Assume the opportunity cost of capital to be 12% for each project. A. "A" has a small, but negative, NPV. B. "B" has a positive NPV when discounted at 10%. C. "C's" cost of capital exceeds its rate of return. D. "D" has a zero NPV when discounted at 14%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

34.

As the discount rate is increased, the NPV of a specific project will: A. increase. B. decrease. C. remain constant. D. decrease to zero, then remain constant. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

35.

A project requires an initial outlay of $10 million. If the cost of capital exceeds the project IRR, then the project has a(n): A. positive NPV. B. negative NPV. C. acceptable payback period. D. positive profitability index. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

36.

The modified internal rate of return can be used to correct for: A. negative NPV calculations. B. multiple internal rates of return. C. undefined payback periods. D. borrowing projects. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Modified internal rate of return

37.

The internal rate of return is most reliable when evaluating: A. a single project with alternating cash inflows and outflows over several years. B. mutually exclusive projects of differing sizes. C. a single project with only cash inflows following the initial cash outflow. D. a single project with cash outflows at time 0 and the final year and inflows in all other time periods. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

38.

When a project's internal rate of return equals its opportunity cost of capital, then the: A. project should be rejected. B. project has no cash inflows. C. net present value will be positive. D. net present value will be zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

39.

Firms that make investment decisions based on the payback rule may be biased toward rejecting projects: A. with short lives. B. with long lives. C. with late cash inflows. D. that have negative NPVs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

40.

One way to increase the NPV of a project is to decrease the: A. project's payback period. B. profitability index. C. time until the receipt of cash inflows. D. number of project IRRs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

41.

What is the IRR for a project that costs $100,000 and provides annual cash inflows of $30,000 for 6 years starting one year from today? A. 19.91% B. 16.67% C. 15.84% D. 22.09% Using a financial calculator: n = 6; PV = −$100,000; PMT = $30,000; FV = 0; CPT i = 19.91%

AACSB: Technology Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

42.

What is the IRR of a project that costs $100,000 and provides cash inflows of $17,000 annually for 6 years? A. 0.57% B. 1.21% C. 5.69% D. 12.10% Using a financial calculator: n = 6; PV = −$100,000; PMT = $17,000; FV = 0; CPT i = 0.57%

43.

An investment costs $100,000 and provides a cash inflow of $17,000 per year. If the discount rate is 13%, how long must the cash inflows last for it to be an acceptable investment? A. 24 years B. 6 years C. 10 years D. 12 years NPV = 0 = −$100,000 + $17,000[(1 / 0.13) − 1 / 0.13(1.13) n]; n = 12 years

44.

If a project costs $72,000 and returns $18,500 per year for 5 years, what is its IRR? A. 8.98% B. 7.39% C. 8.50% D. 7.67% Using a financial calculator: n = 5; PV = −$72,000; PMT = $18,500; FV = 0; CPT i = 8.98%

45.

If the IRR for a project is 15%, then the project's NPV would be: A. negative at a discount rate of 10%. B. positive at a discount rate of 20%. C. negative at a discount rate of 20%. D. positive at a discount rate of 15%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

46.

As long as the NPV of a project declines smoothly with increases in the discount rate, the project is acceptable if its: A. internal rate of return is positive. B. payback period is greater than one. C. rate of return exceeds the cost of capital. D. cash inflows equal the initial cost. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

47.

A project can have as many different internal rates of return as it has: A. cash inflows. B. cash outflows. C. periods of cash flow. D. changes in the sign of the cash flows. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

48.

What is the NPV for the following project cash flows at a discount rate of 15%? C0 = −$1,000, C1 = $700, C2 = $700. A. ($308.70) B. ($138.00) C. $138.00 D. $308.70 NPV = −$1,000 + $700[(1 / 0.15) − 1 / 0.15(1.15) 2] = $138.00

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

49.

What is the IRR of a project with the following cash flows: C0 = −$200, C1 = $ 110, C2 = $121? A. Zero B. 10% C. 18% D. 5% AACSB: Technology Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

50.

A project costing $20,000 generates cash inflows of $9,000 annually for the first 3 years, followed by cash outflows of $1,000 annually for 2 years. At most, this project has ______ different IRR(s). A. one B. two C. three D. five AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

51.

How many IRRs are possible for the following set of cash flows? CF0 = −$1,000, C1 = $500, C2 = −$300, C3 = $1,000, C4 = $200. A. One B. Two C. Three D. Four AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

52.

Given a particular set of project cash flows, which one of the following statements must be correct? A. There can be only one NPV for the project. B. There can be only one IRR for the project. C. There can be more than one IRR for the project. D. There can be up to two profitability indexes for any project. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

53.

When projects are mutually exclusive, you should choose the project with the: A. longer life. B. larger initial size. C. highest IRR. D. highest NPV. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Mutually exclusive projects

54.

When managers select correctly from among mutually exclusive projects, they: A. may give up rate of return for NPV. B. may give up NPV for rate of return. C. have a tendency to select the largest project. D. focus on the payback method to avoid conflicting signals. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Mutually exclusive projects

55.

When evaluating mutually exclusive projects, remember: A. the project with the higher IRR may have the higher NPV at one discount rate and a lower NPV at another . B. cash flows cannot be discounted when considering mutually exclusive projects. C. mutually exclusive projects produce negative IRR values. D. mutually exclusive projects always have multiple IRRs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

56.

Two mutually exclusive projects have the same IRR. When will you be indifferent between them? A. When the IRR is equal to the cost of capital. B. Always if they have the same IRR. C. When the IRR is less than the cost of capital. D. When there is only one change in the sign of the cash flows. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Mutually exclusive projects

57.

When managers cannot determine whether to invest now or wait until costs decrease later, the rule should be to: A. postpone until costs reach their lowest level. B. invest now to maximize the NPV. C. postpone until the opportunity cost reaches its lowest level. D. invest at the date that provides the highest NPV today. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Net present value

58.

You are analyzing a project that is equivalent to borrowing money. This project's: A. NPV graph rises as discount rates decrease. B. initial cash flow is an outflow of funds. C. value increases when the cost of capital increases. D. acceptance requires its IRR to exceed the cost of capital. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

59.

If two machines produce the same product but have different lives, you should choose the machine with the: A. highest IRR. B. longest life. C. lowest equivalent annual cost. D. highest NPV, discounted at the opportunity cost of capital. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

60.

Which mutually exclusive project would you select, if both are priced at $1,000 and your required return is 15%: Project A with three annual cash flows of $1,000; or Project B, with 3 years of zero cash flow followed by 3 years of $1,500 annually? A. Project A B. Project B C. You are indifferent since the NPVs are equal. D. Neither project should be selected. NPVA = −$1,000 + $1,000[(1 / 0.15) − 1 / 0.15(1.15)3] = $1,283.23 NPVB = −$1,000 + {$1,500[(1 / 0.15) − 1 / 0.15(1.15) 3]} / 1.153 = $1,251.89

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

61.

What is the possible cost of capital rationing? A. The firm may have excess fixed assets. B. The firm is likely to take too many risky projects. C. The firm may miss out on positive NPV opportunities D. The firm may have too high a cost of capital. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Capital rationing

62.

Soft capital rationing: A. is costly to shareholders. B. is used to evaluate mutually exclusive projects. C. should be costless to the shareholders of the firm. D. solves the problem of investment timing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Capital rationing

63.

Soft capital rationing is imposed upon a firm by _____, while hard capital rationing is imposed by _____. A. management; the capital market. B. the capital market; management. C. the government; the capital market. D. the capital market; the government. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Capital rationing

64.

If a project has a cost of $50,000 and a profitability index of 2, then: A. it has a negative NPV. B. its NPV could be positive or negative depending on the cost of capital. C. its cash flow is $100,000. D. it has a positive NPV. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

65.

In simple cases when hard capital rationing exists, projects may be evaluated by : A. the payback period. B. mutually exclusive IRRs. C. a profitability index. D. the modified internal rate of return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

66.

Use of a profitability index to evaluate mutually exclusive projects in the absence of capital rationing: A. will provide the same rankings as an NPV criterion. B. will maximize NPV, but not IRR. C. can result in misguided selections. D. is technically impossible. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

67.

The profitability index selects projects based on the: A. highest net discounted value at time zero. B. highest internal rate of return. C. largest dollar investment per rate of return. D. largest return per dollar invested. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

68.

Which of the following investment criteria takes the time value of money into consideration? A. Net present value only B. Profitability index and net present value only C. Internal rate of return and net present value only D. Profitability index, internal rate of return, and net present value AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

69.

When calculating a project's payback period, cash flows are: A. discounted at the opportunity cost of capital. B. discounted at the internal rate of return. C. discounted at the risk-free rate of return. D. not discounted at all. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

70.

What is the profitability index for a project costing $40,000 and returning $15,000 annually for 4 years at an opportunity cost of capital of 12%? A. 0.139 B. 0.320 C. 0.500 D. 0.861 PI = {−$40,000 + $15,000[(1 / 0.12) − 1 / 0.12(1.12) 4]} / $40,000 = 0.139

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

71.

Which of the following statements is true for a project with a $20,000 initial cost, cash inflows of $6,667 per year for 6 years, and a discount rate of 15%? A. Its payback period is 3 years. B. Its NPV is $2,094. C. Its IRR is 17.85%. D. Its profitability index is 0.104. Payback = $20,000 / $6,667 = 3 years NPV = −$20,000 + $6,667[(1 / 0.15) − 1 / 0.15(1.15)6] = $5,231 PI = $5,231 / $20,000 = 0.262IRR = 24.3%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

72.

The "gold standard" of investment criteria refers to the: A. net present value rule. B. internal rate of return rule. C. payback rule. D. profitability index rule. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

73.

Which of the following investment decision rules tends to improperly reject long-lived projects? A. Net present value B. Internal rate of return C. Payback period D. Profitability index AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

74.

The ratio of net present value to initial investment is known as the: A. net present value. B. internal rate of return. C. payback period. D. profitability index. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

75.

For mutually exclusive projects, the IRR can be used to select the best project: A. by calculating the modified internal rate of return. B. by calculating the IRR based on incremental cash flows. C. by using the discount rate to calculate the IRR. D. never. IRR cannot be utilized for mutually exclusive projects. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Mutually exclusive projects

76.

The opportunity cost of capital is equal to: A. the discount rate that makes the project NPV equal zero. B. the return that shareholders could expect by investing their money in the financial markets. C. a project's internal rate of return. D. the average rate of return for a firm's projects. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Capital budgeting

77.

Occasionally projects may have positive initial cash flows. Such projects: A. are like lending money. B. are like borrowing money. C. have no IRR. D. their IRR increases as the cost of capital increases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

78.

A project with an IRR that is less than the opportunity cost of capital should be: A. accepted for all projects. B. accepted only for projects with a positive initial cash flow. C. accepted only for projects with a negative initial cash flow. D. rejected for all projects. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

79.

If a project's expected rate of return exceeds its opportunity cost of capital, one would expect: A. the profitability index to be negative. B. the opportunity cost of capital to be too low. C. the project to have a positive NPV. D. the NPV to be zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

80.

Which one of the following should be assumed about a project that requires a $100,000 investment at time zero, then returns $20,000 annually for 5 years? A. The NPV is negative. B. The NPV is zero. C. The profitability index is 1.0. D. The IRR is negative. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

81.

If two projects offer the same positive NPV, then they: A. also have the same IRR. B. have the same payback period. C. are mutually exclusive projects. D. add the same amount of value to the firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

82.

What is the minimum cash flow that could be received at the end of year 3 to make the following project "acceptable"? Initial cost = $100,000; cash flows at end of years 1 and 2 = $35,000; opportunity cost of capital = 10%. A. $29,494 B. $30,000 C. $39,256 D. $52,250 NPV = 0 − $100,000 + ($35,000 / 1.1) + $35,000 / 1.12 + $x / 1.13; x = $52,250 A cash flow of $52,250 received in year 3, and discounted at 10%, would increase the NPV to zero.

83.

According to the NPV rule, all projects should be accepted if NPV is positive when discounted at the: A. internal rate of return. B. opportunity cost of capital. C. risk-free interest rate. D. accounting rate of return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-01 Calculate the net present value of a project. Topic: Net present value

84.

If a project's IRR is 13% and the project provides annual cash flows of $15,000 for 4 years, how much did the project cost? A. $44,617.07 B. $52,208.18 C. $41,909.29 D. $49,082.11 PV = $15,000 (1 / 0.13) − [1 / 0.13(1.13) 4] = $44,617.07

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

85.

A project's payback period is determined to be 4 years. If it is later discovered that additional cash flows will be generated in years 5 and 6, then the project's payback period will: A. be reduced. B. be increased. C. be unchanged. D. change but the discount rate must be known to determine the nature of the change. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Payback

86.

A polisher costs $10,000 and will cost $20,000 a year to operate and maintain. If the discount rate is 10% and the polisher will last for 5 years, what is the equivalent annual cost of the tool? A. $17,163.04 B. $22,187.84 C. $22,637.98 D. $19,411.15 PV = −$10,000 + −$20,000[(1 / 0.1) − 1 / 0.1(1.1)5] = −$85,815.74 The equivalent annual cost is the payment with the same present value. So, using a financial calculator: n = 5; i = 10%; PV = −$85,815.74; FV = 0; CPT PMT = $22,637.98

AACSB: Technology Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

87.

Selecting the project(s) with the highest NPV(s) is not the correct decision rule when: A. there is capital rationing. B. there are mutually exclusive projects. C. projects are long-lived. D. projects are independent. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Capital rationing

88.

The investment timing problem arises when: A. cash flows may occur at the beginning or end of each time period. B. there is a choice between using the payback or NPV rules. C. the project has a positive initial cash flow. D. investment can occur now or at some future point. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Capital budgeting

89.

A company owns a tract of timber that will keep growing for a number of years. It calculates that the timber’s value less the cost of harvesting is currently $50,000 and that this figure will grow by 10% in the next year and by 5% in the following year. If the cost of capital is 8%, when should the company harvest the timber? A. today. B. year 1. C. year 2. D. harvest a third of the timber each year. If harvested in year 1, the timber will have an NPV in year 1 of $50,000 × 1.10 = $55,000, and an NPV today of $55,000 / 1.08 = $50,926 If harvested in year 2, it will have an NPV is year 2 of $55,000 × 1.05 = $57,750 and an NPV today of $57,750 / 1.08 2 = $49,511

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Capital budgeting

90.

To justify postponing a project for one year, the NPV needs to increase over that year by a rate that is equal to or greater than: A. the project's IRR. B. the risk-free rate. C. the cost of capital. D. zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Capital budgeting

91.

What happens to the equivalent annual cost of a project as the opportunity cost of capital decreases? A. It increases. B. It decreases. C. It is not affected. D. It depends on whether or not the projects are mutually exclusive. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

92.

What is the equivalent annual cost for a project that requires a $40,000 investment at time zero, and a $10,000 annual expense during each of the next 4 years, if the opportunity cost of capital is 10%? A. $20,000.00 B. $21,356.95 C. $22,618.83 D. $25,237.66 NPV = −$40,000 − $10,000[(1 / 0.1) − 1 / 0.1(1.1) 4] = −$71,698.65 The EAC is the payment that has the same NPV given 4 years and a 10% discount rate. So, using a financial calculator: n = 4; i = 10%; PV = −$71,698.65; FV = 0; CPT PMT = $22,618.83

expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

93.

A currently used machine costs $10,000 annually to run. What is the maximum that should be paid to replace the machine with one that will last 3 years and cost only $4,000 annually to run? The opportunity cost of capital is 12%. A. $15,209.84 B. $9,607.33 C. $14,410.99 D. $10,338.56 NPV = [−$10,000 − (−$4,000)][(1 / 0.12) − 1 / 0.12(1.12) 3] = $14,410.99

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

94.

Because of its age, your car costs $4,000 annually in maintenance expense. You could replace it with a newer vehicle costing $8,000. Both vehicles would be expected to last 4 more years, at which point they will be valueless. If your opportunity cost is 8%, by how much must maintenance expense decrease on the newer vehicle to justify its purchase? A. $1,625.40 B. $1,584.63 C. $1,469.08 D. $1,409.54 $8,000 = PMT [(1 / 0.08) − 1 / 0.08(1.08)4]; PMT = $2,415.37 Maintenance expense decrease required = $4,000 − 2,415.37 = $1,584.63

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

95.

Projects A and B are mutually exclusive lending projects. Project A has an IRR of 20% while Project B has an IRR of 30%. You would be more likely to choose B unless: A. Project B has a longer life than Project A. B. Project A has more risk than Project B. C. Project A is twice the size of Project B. D. Project B has a larger cash inflow in Year 1 than Project A. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Mutually exclusive projects

96.

What is the decision rule in the case of sign changes that produce multiple IRRs for a project? A. Select the lowest IRR to be conservative B. Select the highest IRR to maximize the benefits C. Any or all of the IRRs are justified to use D. Calculate the modified internal rate of return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

97.

If a project has a payback period of 5 years and a cost of capital of 10%, then the discounted payback will: A. exceed 5 years. B. be less than 5 years. C. decrease if the cost of capital increases. D. decrease if the payback period increases due to revised cash flows. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off. Topic: Discounted payback

98.

You can continue to use your less efficient machine at a cost of $8,000 annually. Alternatively, you can purchase a more efficient machine for $12,000 plus $5,000 annual maintenance. If the new machine lasts 5 years and the cost of capital is 15%, you should: A. buy the new machine and save $600 in equivalent annual costs. B. buy the new machine and save $388 in equivalent annual costs. C. keep the old machine and save $388 in equivalent annual costs. D. keep the old machine and save $580 in equivalent annual costs. NPV = −$12,000 − $5,000[(1 / 0.15) − 1 / 0.15(1.15)5] = −$28,760.78 Using a financial calculator: N = 5; I = 15%; PV = −$28,760.78; FV = 0; CPT PMT = $8,579.79 Change in annual cost = $8,579.79 − 8,000 = $579.79

AACSB: Technology Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-05 Use the net present value rule to analyze three common problems that involve competing projects: (a) when to postpone an investment expenditure; (b) how to choose between projects with unequal lives; and (c) when to replace equipment. Topic: Equivalent annual costs

99.

A firm is considering a project with the following cash flows: Time 0 = +$20,000, Years 1-5 = −$4,500. Should the project be accepted if the cost of capital is 10%? A. Yes; The IRR of the project is 4.06%. B. Yes; The IRR of the project is 12.5%. C. No; The IRR of the project is 4.06%. D. No; The IRR of the project is 12.5%. Using a financial calculator: n = 5; PV = $20,000; PMT = −$4,500; FV = 0; CPT i = 4.06% Given the cash flow signs, it resembles borrowing at 4.06% and, therefore, it is acceptable if this is less than the cost of capital.

AACSB: Technology Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule. Topic: Internal rate of return

100.

A firm plans to use the profitability index to select between two mutually exclusive investments. If no capital rationing has been imposed, which project should be selected? A. Select the project with the higher profitability index B. Select the project with the lower profitability index C. Without capital rationing, both projects can be selected D. Without capital rationing, the NPV method must be used instead AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited. Topic: Profitability index

Chapter 08 Test bank - Static Summary Category AACSB: Analytical Thinking

# of Questio ns 16

AACSB: Communication

AACSB: Reflective Thinking

AACSB: Technology

Accessibility: Keyboard Navigation

100

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

100

Learning Objective: 08-01 Calculate the net present value of a project.

Learning Objective: 08-02 Calculate the internal rate of return of a project and know what to look out for when using the internal rate of return rule.

Learning Objective: 08-03 Calculate the profitability index and use it to choose between projects when funds are limited.

Learning Objective: 08-04 Understand the payback rule and explain why it doesn't always make shareholders better off.

Topic: Capital budgeting

Topic: Capital rationing

Topic: Discounted payback

Topic: Equivalent annual costs

Topic: Internal rate of return

Topic: Modified internal rate of return

Topic: Mutually exclusive projects

Topic: Net present value

Topic: Payback

Topic: Profitability index

Chapter 09 Test bank - Static Student: ___________________________________________________________________________

Capital budgeting analysis focuses on cash flow as opposed to profits. True

Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows. True

False

An asset in the MACRS 5-year class life will have depreciation expense in 6 different years. True

False

A reduction in working capital increases cash flows. True

False

In project analysis, allocations of overhead should be limited to those that represent additional expense. True

False

The method of financing a project affects the determination of its cash flows for capital budgeting purposes. True

False

Opportunity costs are evaluated for investment decisions at their historical cost. True

False

Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash inflows. True

False

The present value of the total depreciation tax shield will be higher when an asset uses MACRS than when depreciated straightline. True

False

10. If a firm sells an asset for more than its value in the IRS’s books, the resulting net cash flow will be less than the sales price. True

False

11. When a firm makes an investment in working capital, the cash is usually recovered later. True

False

12. Discounting real cash flows with real interest rates provides an overly optimistic idea of a project's value. True

False

13. Sunk costs remain the same whether or not you accept the project. True

False

14. Sunk costs do not affect the net present value of a project. True

False

15. Investments in working capital, just like investments in plant and equipment, result in cash inflows. True

False

16. A project will always generate extra overhead costs. True

False

17. Discounting real cash flows at a nominal rate is a serious mistake. True

False

18. Suppose you finance a project partly with debt. You should neither subtract the debt proceeds from the project's required investment, nor would you recognize the interest and principal payments on the debt as cash outflows. True

False

19. When you finance a project partly with debt, you should still view the project as if it were all equity-financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as going to them. True

False

20. As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash flow as inventories are sold off and accounts receivable are collected. True

False

21. The total depreciation tax shield equals the product of depreciation and the tax rate. True

False

22. Cash flow from operations = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax rate). True

False

23. Corporate income statements are designed primarily to show: A. cash flows during a period. B. account balances at the end of a period. C. performance during a period. D. market values of assets and liabilities.

24. Projects that have negative NPVs should be: A. depreciated over a longer time period. B. charged less in overhead costs. C. discounted using lower rates. D. rejected or abandoned. 25. If the adoption of a new product will reduce the sales of an existing product, then the project cash flows should: A. reflect only the sales of the new product. B. include only the reduction amount. C. be reduced by the cash that would have been generated by those sales. D. be adjusted upward by the reduction amount. 26. Which one of these represents a cash outflow for a project? A. A sunk cost B. Increase in accounts receivable C. Depreciation D. Accrued expenses 27. The rationale for not including sunk costs in capital budgeting decisions is that they: A. are usually small in magnitude. B. revert at the end of the investment. C. have no incremental effect on project cash flows. D. reduce the project's net present value. 28. You are considering the introduction of a new product that will require an investment in new machinery. Which one of these will lower the net present value of that project? A. A reduction in the firm's total variable costs due to the purchase of the new machine B. A loss of sales of existing products due to the introduction of the new product C. The increase in annual depreciation resulting from the asset purchase D. The sale of the machine after it is fully depreciated 29. When is it appropriate to include sunk costs in the evaluation of a project? A. Whenever they are relatively large B. If they improve the project's NPV C. If they are considered to be overhead costs D. Never 30. A firm invests in a 7-year project that requires the purchase of a $135,000 machine tool. This will be depreciated using 5-year MACRS and will have no salvage value. When will this equipment affect the project's tax payments? A. Every year for 5 years B. At the time of purchase only C. Every year for 6 years D. Every year for 7 years

31. The opportunity cost of an asset: A. should be depreciated annually. B. should be included in the project cash flows. C. is typically ignored in capital budgeting. D. is important only for parcels of land. 32. Which one of the following is least likely to influence the opportunity cost of an asset? A. Its current market value B. Alternative uses for the asset C. The current demand for the asset D. Its current book value 33. Assume your firm has an unused machine that originally cost $75,000, has a book value of $20,000, and a market value of $25,000. Ignoring taxes, what is the opportunity cost of using this machine? A. $75,000 B. $25,000 C. $20,000 D. $5,000 34. Which one of the following changes in working capital is least likely if sales increase? A. An increase in inventories B. An increase in accounts payable C. A decrease in accounts receivable D. An increase in notes payable 35. A proposed project requires an initial investment of $8,500 in current assets, 75% of which will be financed with accounts payable. The project will have: A. an initial cash outflow of $8,500 at time zero for net working capital. B. a cash outflow for net working capital at the end of the project. C. a cash inflow at the end of the project from net working capital. D. a cash outflow for net working capital every year of the project's life. 36. In which of the following cases will a cash investment in net working capital be most likely? A. Inventory levels will be reduced when the project is introduced. B. All sales related to the project will be cash sales to a subsidiary. C. The project will increase inventory more than accounts payable. D. The project will require additional inventory which will be financed by a supplier. 37. What is the effect on a firm's net working capital if a new project requires a $30,000 increase in inventory, a $10,000 increase in accounts receivable, a $35,000 expenditure on machinery, and a $20,000 increase in accounts payable? A. −$5,000 B. $10,000 C. $20,000 D. $55,000

38. A project is expected to increase inventory by $17,000, increase accounts payable by $10,000, and decrease accounts receivable by $1,000. What is the project's cash flow from net working capital at time zero? A. −$8,000 B. $8,000 C. −$6,000 D. $6,000 39. Net working capital is expected to increase by $25,000 in year 5 of a project. If this extra working capital is recovered when the project ends in year 6, what is the effect on the project's net present value, if the cost of capital is 15%? A. NPV will not be affected because the $25,000 will all be recouped. B. NPV will increase by $12,429.42. C. NPV will decrease by $25,000. D. NPV will decrease by $1,621.23. 40. Investments in working capital: A. are simply accounting entries and do not affect NPV. B. do not matter because the cash is generally recovered when the project ends. C. increase NPV because they make the project more valuable. D. reduce project NPV. 41. Changes in net working capital can occur at: A. the beginning of a project. B. the end of a project. C. any time during the life of a project. D. the beginning of any accounting period. 42. What effect is likely at the end of the life of a project that required a $20,000 investment in net working capital? A. The $20,000 must now be paid by the firm. B. The firm receives a $20,000 cash inflow. C. Taxable income is reduced by $20,000. D. No effects are expected because the $20,000 is now a sunk cost. 43. Allocations of overheads should not affect a project's incremental cash flows unless the: A. project actually changes the total amount of overhead expenses. B. overhead will not be recovered at the end of the project. C. overhead is not currently fully allocated to existing projects. D. accountant is required to allocate costs to this project. 44. The NPV of an investment proposal becomes negative solely as a result of allocating a portion of the corporation president's salary. It is most likely the case that: A. the project should be accepted. B. rejecting the project is the correct decision. C. the allocation should be postponed until the project is accepted. D. the salary should be considered an opportunity cost of the project.

45. The correct method to handle overhead costs in capital budgeting is to: A. allocate a portion to each project. B. allocate them to projects with the highest NPVs. C. ignore all except incremental amounts. D. ignore them in all cases. 46. Which one of the following would not be expected to affect the decision of whether to undertake an investment? A. Income tax rates B. Estimates of future inflation rates C. Sales reductions in other products caused by this investment D. Cost of the feasibility study that was conducted for this project 47. Which one of the following methods will provide a correct analysis for capital budgeting purposes? A. Discounting real cash flows with real rates. B. Discounting real cash flows with nominal rates. C. Discounting nominal cash flows with real rates. D. Discounting nominal cash flows with either real or nominal rates. 48. The likely effect of discounting nominal cash flows with real interest rates will be to: A. make an investment's NPV appear more attractive. B. make an investment's NPV appear less attractive. C. correctly calculate an investment's NPV if inflation is expected. D. correctly calculate an investment's NPV, regardless of expected inflation. 49. Your forecast shows $500,000 annually in sales for each of the next 3 years. If your second and third year predictions have failed to incorporate the 3% expected annual inflation, how far off in total dollar sales is your 3-year forecast? A. $45,450 B. $60,900 C. $52,550 D. $76,250 50. Which one of the following would be more apt to make an unacceptable project appear acceptable? A. Discounting real cash flows with real rates B. Discounting nominal cash flows with real rates C. Discounting real cash flows with nominal rates D. Discounting nominal cash flows with nominal rates 51. Capital budgeting proposals should be evaluated as if the project were financed: A. entirely by debt. B. entirely by equity. C. half by debt and half by equity. D. with the highest cost source of funds, to be safe.

52. When calculating cash flow from operations, one should: A. subtract depreciation since it represents the cost of replacing worn-out equipment. B. deduct the depreciation tax shield from after-tax profit. C. use after-tax profit and ignore depreciation. D. add depreciation to after-tax profit. 53. The recovery of an additional investment in working capital is likely to: A. occur at the end of a project's life. B. occur at the beginning of a project's life. C. occur whenever the project first shows a profit. D. be a sunk cost. 54. In what manner does depreciation expense affect investment projects? A. It reduces cash flows by the amount of the depreciation expense. B. It increases cash flows by the amount of the depreciation expense. C. It reduces taxable income by the amount of the depreciation expense. D. It reduces taxes by the amount of the depreciation expense. 55. Given a positive discount rate, which one of the following changes would increase the NPV of a project? A. Increasing the firm's opportunity cost of capital B. Reducing the amount of working capital that is needed. C. Spreading the total cash inflows over a longer time interval D. Increasing the project's estimated expenses 56. What is the annual depreciation tax shield for a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense? A. $10,500 B. $30,000 C. $35,000 D. $65,000 57. What is the amount of the annual depreciation tax shield for a firm with $200,000 in net income, $75,000 in depreciation expense, and a 35% marginal tax rate? A. $26,250 B. $43,750 C. $70,000 D. $75,000 58. What is the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate? A. $260,000 B. $325,000 C. $360,000 D. $425,000

59. A tax shield is equal to the reduction in a firm's: A. total tax liability resulting from a tax deductible expense. B. taxable income resulting from depreciation. C. taxable income resulting from a decrease in long-term debt. D. net income caused by depreciation. 60. Which one of the following categories would be least likely to require annual adjustments in a capital budgeting analysis due to the effects of inflation? A. Sales B. Expenses C. Working capital D. Depreciation expense 61. Methods of accelerated depreciation: A. allow more total depreciation over the asset's life. B. decrease the depreciation tax shield. C. increase the depreciation tax shield. D. allow assets to be depreciated more rapidly. 62. Why is accelerated depreciation often favored for the corporation's set of tax books? A. It increases the total depreciation tax shield over the project's life. B. It reduces the total amount of taxes paid over the project's life. C. It increases net accounting profits over the project's life. D. It allows the depreciation tax savings to be realized earlier. 63. The modified accelerated cost recovery system (MACRS) allows an increase: A. in total depreciation over the asset's life. B. in annual depreciation during earlier years. C. in real but not nominal depreciation expense. D. in the asset's depreciable cost basis. 64. Under the MACRS: A. all assets are depreciated over 5 years. B. depreciable percentages decline throughout the asset's class life. C. straight-line depreciation percentages are doubled. D. assets are assumed to be purchased and sold midyear. 65. A firm plans to purchase a $50,000 asset that will be depreciated straight-line over a 5-year life to a zero salvage value. What is the present value of the resulting depreciation tax shield if the tax rate is 35% and the discount rate is 10%? A. $10,866.67 B. $13,267.75 C. $17,500.00 D. $37,908.18

66. The present value of the depreciation tax shield at any given discount rate is: A. equal for all depreciation methods. B. higher with MACRS than with straight-line depreciation. C. higher for the 7-year recovery period than for the 5-year recovery period class. D. likely to increase annually due to inflation. 67. When the real rate of interest is less than the nominal rate of interest, then: A. disinflation must be occurring. B. investment returns cannot increase the purchasing power of an investment. C. nominal cash flows should be discounted with real rates. D. the rate of inflation must be positive. 68. When a depreciable asset is ultimately sold, the sales price is: A. fully taxable. B. nontaxable. C. nontaxable only if accelerated depreciation was used. D. taxable to the extent that the sales price exceeds book value. 69. Which one of the following statements regarding depreciation is correct? A. The depreciation tax shield adjusts annually with the level of inflation. B. The real amount of annual depreciation is fixed, thus the higher the rate of inflation, the higher the depreciation tax shield. C. Tax law allows accelerated depreciation to be used for tax purposes. D. MACRS can be used for accounting purposes but not for tax purposes. 70. The statement "We've got too much invested in that project to pull out now" possibly illustrates the need to: A. switch to an accelerated method of depreciation. B. recognize sunk costs. C. reduce net working capital assigned to the project. D. reduce discount rates to improve NPV. 71. What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-tax cash flows from operations, $1,000 from the sale of a fully depreciated machine, a $2,000 investment in working capital, and a 35% tax rate? A. $8,450 B. $12,600 C. $12,650 D. $14,000 72. At a 13% cost of capital, a project's NPV is $100,000 if you invest today. By what amount must the initial cost of the project decrease before you would wish to wait 2 years before investing? Assume all else is held constant. A. $21,685 B. $26,000 C. $27,690 D. $29,380

73. Which of the following correctly adjusts for depreciation when calculating a project’s operating cash flow? A. (revenues − cash expenses) × (1 − tax rate) + (tax rate × depreciation). B. pretax profit + depreciation tax shield. C. after-tax profit − depreciation. D. ignore depreciation since it is not a cash flow. 74. A new inventory system will immediately reduce inventory levels by $100,000. If this reduction is permanent and the cost of capital is 13%, how does the net working capital change affect company value? A. Company value increases by $100,000. B. NPV increases by $13,000. C. Company value will not change. D. Company value increases by $769,231. 75. The opportunity cost of a resource should be considered in project analysis, unless: A. negative cash flows result from its use. B. the resource was purchased in a prior time period. C. the resource has been fully depreciated. D. the resource has no identifiable market value or alternative use within the firm. 76. A new project requires an increase in both current assets and current liabilities of $125,000 each. What is the overall impact on the net working capital investment? A. An increase of zero B. An increase of $125,000 C. An increase of $250,000 D. An increase of $62,500, when averaged over the life of the project 77. The primary difficulty in the allocation of overhead costs to prospective projects is that the: A. allocation will reduce the project's NPV. B. discount rate is unknown. C. costs may not represent an incremental expense. D. expenses may have been previously allocated. 78. If inflation is forecast to increase, which of the company’s following cash flows is most likely to change? A. The depreciation tax shield. B. Labor costs. C. Costs of raw materials purchased on a fixed price contract. D. Interest payments on its long-term debt. 79. A project costs $12,800 and is expected to provide a real cash inflow of $10,000 at the end of each of years 1 through 5. Calculate the net present value of this project if inflation is expected to be 4% in each year and the firm employs a nominal discount rate of 10.76%. A. $33,522.30 B. $28,756.79 C. $33,294.07 D. $26,311.15

80. An investment today of $25,000 promises to return $10,000 annually for the next 3 years. What is the real rate of return on this investment if inflation averages 6% annually during the period? A. 3.49% B. 9.78% C. 4.84% D. 6.38% 81. What nominal annual return is required on an investment for an investor to experience a 12% gain in purchasing power? Assume inflation is 4%. A. 7.69% B. 9.29% C. 12.00% D. 16.48% 82. What is the NPV of a 6-year project that costs $100,000, has annual revenues of $50,000 and costs of $15,000? Assume the investment can be depreciated for tax purposes straight-line over 6 years, the corporate tax rate is 35%, and the discount rate is 14%. A. −$15,560.04 B. $11,151.08 C. $3,411.14 D. $14,782.09 83. An investment of $120,000 can be depreciated for tax purposes straight line over 6 years. The corporate tax rate is 40%. When calculating cash flow: A. the company should deduct a depreciation tax shield of $8,000 a year from after-tax (revenues less cash expenses) B. the company should add a depreciation tax shield of $8,000 a year to after-tax (revenues less cash expenses) C. the company should add a depreciation tax shield of $20,000 a year to after-tax (revenues less cash expenses) D. no adjustment should be made for depreciation since it is not a cash expense. 84. A project that increased sales was accompanied by a $50,000 increase in inventory, a $20,000 increase in accounts receivable, and a $25,000 increase in accounts payable. Assuming these amounts remain constant, by how much has net working capital increased? A. $5,000 B. $25,000 C. $30,000 D. $45,000 85. Which of the following costs probably should not be allocated to the investment needed for a new project? A. Project's required increase in accounts receivable B. New warehouse, built for this project C. A portion of the vice president's salary D. Labor expense for employees involved in the project

86. A parcel of corporate land was recently chosen as the new plant site. What cost allocation should the land receive, based on the following: original cost of $200,000, highest market value during time of ownership of $300,000, net book value of $200,000, a recent offer to purchase for $250,000? A. $200,000 B. $250,000 C. $275,000 D. $300,000 87. Which of the following is true of the depreciation tax shield? A. It increases annually with the rate of inflation. B. It decreases annually in nominal terms. C. It is not altered by inflation. D. The real value of the depreciation is fixed. 88. Assuming an asset has been fully depreciated according to its MACRS class life, which one of the following statements is correct? A. Its market value is zero. B. Its book value is zero. C. Its book value is the current market value. D. It has neither a book value nor a market value. 89. New projects can have multiple effects on a firm. Which one of the following appears to be a positive indirect effect? A. Additional working capital will be required at the start of the project. B. The sales force will need to be increased over the life of the project. C. Sales of replacement parts are expected in the future. D. The cost of employee benefits will increase due to new hires. 90. New projects or products can provide positive indirect effects as well as negative effects. Which one of the following appears to be a negative indirect effect? A. The new machine required for the project uses less electricity than the existing machine. B. Orders for your complementary products are expected to increase. C. Customer orders of supplies for the firm’s existing products are expected to decrease. D. Variable costs are expected to decrease since the firm can order larger quantities. 91. Lew's Metals has a machine sitting idle in its warehouse. The machine originally cost $213,000, has a current book value of $32,300, has a scrap metal value of $13,000, and a market value of $46,900. The machine is totally paid for. What value should be placed on this machine if it is used for a new project? A. $0 B. $13,000 C. $32,300 D. $46,900

92. A project requires an additional commitment of $100,000 in net working capital in each of years 1 to 4. These extra investments can be recovered in year 5 when the project comes to an end. What is the effect on NPV? A. NPV is reduced by $100,000. B. NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for 4 years. C. NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for each of years 1 to 4 minus the discounted value of the $400,000 that is recovered in year 5. D. No opportunity cost is involved. 93. The additional inventory investment that is often required for new projects is partially offset by: A. switching to accelerated depreciation methods. B. reducing accounts receivable. C. decreasing equipment purchases. D. increasing accounts payable. 94. What rate of nominal growth is expected in sales if they are currently $1,000,000 and are expected to reach $1,600,000 in 5 years? Assume an inflation rate of 3.5%. A. 3.20% B. 9.86% C. 12.00% D. 26.49% 95. What is the effect of using MACRS rather than straight-line depreciation? A. It increases the NPV. B. The total amount of depreciation is increased. C. It allows asset book values to increase with market values. D. It increases gross fixed assets. 96. In the MACRS depreciation schedules, the depreciation percentage is lower in the first year than in the second year. This is due to the fact that: A. the depreciation percentage increases every year over the project's life. B. assets are assumed to be acquired at midyear. C. depreciation expense increases at the rate of inflation. D. MACRS depreciation is less attractive than straight-line depreciation. 97. A firm invests $10 million in a new stamping machine. It depreciates it straight line for tax purposes over 5 years. The tax rate is 30%, inflation is 4% a year, and the discount rate is 8%. What is the PV of the depreciation tax shield? A. $600,000. B. $2,395,626. C. $2,579,497. D. $3,000,000.

98. Capital budgeting projects typically assume that all cash flows transpire at the end of the year. The reason for this is that: A. less tax liability results from this practice. B. balance sheets are prepared at the end of the year. C. it simplifies the analysis and the resulting errors are usually small compared with the errors in forecasting future cash flows. D. most corporations collect their cash at the end of the year. 99. Which one of the following is not accurate in depicting the cash flows from operations for an all-equity firm? A. (revenues − cash expenses)(1 − tax rate) + (depreciation × tax rate) B. (revenues − expenses − taxes) C. (net profit + depreciation) D. (revenues − cash expenses − taxes) 100. Which of the following typically results from using straight-line depreciation rather than MACRS in the set of books for shareholders? A. Net income appears higher during the early periods of depreciation. B. Less money is paid to the Internal Revenue Service over an asset's life. C. Financial managers have more funds from operations available over the asset's life. D. Cash flow from operations will be higher in the second year of the asset's life. 101. When you evaluate a proposed project you should: A. allocate a percentage of current overhead costs to the project. B. include all indirect effects. C. include sunk costs. D. ignore opportunity costs. 102. Which one of the following formulas is incorrect? A. Operating cash flow = revenues − cash expenses − taxes B. Operating cash flow = net profit + depreciation C. Depreciation tax shield = depreciation × (1 − tax rate) D. Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax rate) 103. Which one of these statements is incorrect? A. Real cash flows must be discounted at a real discount rate. B. (1 + real rate of interest) = (1 + nominal rate of interest) / (1 + inflation rate) C. The actual real rate of interest almost equals "nominal rate of interest − inflation rate." D. Inflation rate = nominal rate / real rate − 1 104. Which of the following statements regarding investment in working capital is incorrect? A. An investment in working capital, unlike an investment in plant and equipment, represents a positive cash flow when the investment is made. B. Net working capital cash flow is measured by the change in working capital, not the level of working capital. C. Net working capital may change during the life of a project. D. Working capital is generally recovered at the end of a project.

Chapter 09 Test bank - Static Key 1.

Capital budgeting analysis focuses on cash flow as opposed to profits. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash inflows. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

Opportunity costs are evaluated for investment decisions at their historical cost. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

The method of financing a project affects the determination of its cash flows for capital budgeting purposes. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy

Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

In project analysis, allocations of overhead should be limited to those that represent additional expense. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

A reduction in working capital increases cash flows. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

An asset in the MACRS 5-year class life will have depreciation expense in 6 different years. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

The present value of the total depreciation tax shield will be higher when an asset uses MACRS than when depreciated straight-line. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

10.

If a firm sells an asset for more than its value in the IRS’s books, the resulting net cash flow will be less than the sales price. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic

Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Cash flows

11.

When a firm makes an investment in working capital, the cash is usually recovered later. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

12.

Discounting real cash flows with real interest rates provides an overly optimistic idea of a project's value. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

13.

Sunk costs remain the same whether or not you accept the project. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

14.

Sunk costs do not affect the net present value of a project. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

15.

Investments in working capital, just like investments in plant and equipment, result in cash inflows. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Net working capital

16.

A project will always generate extra overhead costs. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Fixed and variable costs

17.

Discounting real cash flows at a nominal rate is a serious mistake. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

18.

Suppose you finance a project partly with debt. You should neither subtract the debt proceeds from the project's required investment, nor would you recognize the interest and principal payments on the debt as cash outflows. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

19.

When you finance a project partly with debt, you should still view the project as if it were all equity-financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as going to them. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

20.

As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash flow as inventories are sold off and accounts receivable are collected. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

21.

The total depreciation tax shield equals the product of depreciation and the tax rate. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

22.

Cash flow from operations = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax rate). TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Operating cash flow

23.

Corporate income statements are designed primarily to show: A. cash flows during a period. B. account balances at the end of a period. C. performance during a period. D. market values of assets and liabilities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-02 Calculate the cash flows of a project from standard financial statements. Topic: Income statement

24.

Projects that have negative NPVs should be: A. depreciated over a longer time period. B. charged less in overhead costs. C. discounted using lower rates. D. rejected or abandoned. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

25.

If the adoption of a new product will reduce the sales of an existing product, then the project cash flows should: A. reflect only the sales of the new product. B. include only the reduction amount. C. be reduced by the cash that would have been generated by those sales. D. be adjusted upward by the reduction amount. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Pro forma statements

26.

Which one of these represents a cash outflow for a project? A. A sunk cost B. Increase in accounts receivable C. Depreciation D. Accrued expenses AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

27.

The rationale for not including sunk costs in capital budgeting decisions is that they: A. are usually small in magnitude. B. revert at the end of the investment. C. have no incremental effect on project cash flows. D. reduce the project's net present value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

28.

You are considering the introduction of a new product that will require an investment in new machinery. Which one of these will lower the net present value of that project? A. A reduction in the firm's total variable costs due to the purchase of the new machine B. A loss of sales of existing products due to the introduction of the new product C. The increase in annual depreciation resulting from the asset purchase D. The sale of the machine after it is fully depreciated AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project.

Topic: Project analysis and evaluation

29.

When is it appropriate to include sunk costs in the evaluation of a project? A. Whenever they are relatively large B. If they improve the project's NPV C. If they are considered to be overhead costs D. Never AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

30.

A firm invests in a 7-year project that requires the purchase of a $135,000 machine tool. This will be depreciated using 5year MACRS and will have no salvage value. When will this equipment affect the project's tax payments? A. Every year for 5 years B. At the time of purchase only C. Every year for 6 years D. Every year for 7 years AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Cash flows

31.

The opportunity cost of an asset: A. should be depreciated annually. B. should be included in the project cash flows. C. is typically ignored in capital budgeting. D. is important only for parcels of land. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

32.

Which one of the following is least likely to influence the opportunity cost of an asset?

A. Its current market value B. Alternative uses for the asset C. The current demand for the asset D. Its current book value AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

33.

Assume your firm has an unused machine that originally cost $75,000, has a book value of $20,000, and a market value of $25,000. Ignoring taxes, what is the opportunity cost of using this machine? A. $75,000 B. $25,000 C. $20,000 D. $5,000 AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

34.

Which one of the following changes in working capital is least likely if sales increase? A. An increase in inventories B. An increase in accounts payable C. A decrease in accounts receivable D. An increase in notes payable AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

35.

A proposed project requires an initial investment of $8,500 in current assets, 75% of which will be financed with accounts payable. The project will have: A. an initial cash outflow of $8,500 at time zero for net working capital. B. a cash outflow for net working capital at the end of the project. C. a cash inflow at the end of the project from net working capital. D. a cash outflow for net working capital every year of the project's life. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

36.

In which of the following cases will a cash investment in net working capital be most likely? A. Inventory levels will be reduced when the project is introduced. B. All sales related to the project will be cash sales to a subsidiary. C. The project will increase inventory more than accounts payable. D. The project will require additional inventory which will be financed by a supplier. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

37.

What is the effect on a firm's net working capital if a new project requires a $30,000 increase in inventory, a $10,000 increase in accounts receivable, a $35,000 expenditure on machinery, and a $20,000 increase in accounts payable? A. −$5,000 B. $10,000 C. $20,000 D. $55,000 Change in NWC = $30,000 + 10,000 − 20,000 = $20,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

38.

A project is expected to increase inventory by $17,000, increase accounts payable by $10,000, and decrease accounts receivable by $1,000. What is the project's cash flow from net working capital at time zero? A. −$8,000 B. $8,000 C. −$6,000 D. $6,000 Cash flow0 = −$17,000 + 10,000 + 1,000 = −$6,000

39.

Net working capital is expected to increase by $25,000 in year 5 of a project. If this extra working capital is recovered when the project ends in year 6, what is the effect on the project's net present value, if the cost of capital is 15%? A. NPV will not be affected because the $25,000 will all be recouped. B. NPV will increase by $12,429.42. C. NPV will decrease by $25,000. D. NPV will decrease by $1,621.23. ΔNPV = −$25,000 / 1.155 + 25,000 / 1.156 = $1,621.23

40.

Investments in working capital: A. are simply accounting entries and do not affect NPV. B. do not matter because the cash is generally recovered when the project ends. C. increase NPV because they make the project more valuable. D. reduce project NPV. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

41.

Changes in net working capital can occur at: A. the beginning of a project. B. the end of a project. C. any time during the life of a project. D. the beginning of any accounting period. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

42.

What effect is likely at the end of the life of a project that required a $20,000 investment in net working capital? A. The $20,000 must now be paid by the firm. B. The firm receives a $20,000 cash inflow. C. Taxable income is reduced by $20,000. D. No effects are expected because the $20,000 is now a sunk cost. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

43.

Allocations of overheads should not affect a project's incremental cash flows unless the: A. project actually changes the total amount of overhead expenses. B. overhead will not be recovered at the end of the project. C. overhead is not currently fully allocated to existing projects. D. accountant is required to allocate costs to this project. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

44.

The NPV of an investment proposal becomes negative solely as a result of allocating a portion of the corporation president's salary. It is most likely the case that: A. the project should be accepted. B. rejecting the project is the correct decision. C. the allocation should be postponed until the project is accepted. D. the salary should be considered an opportunity cost of the project. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

45.

The correct method to handle overhead costs in capital budgeting is to: A. allocate a portion to each project. B. allocate them to projects with the highest NPVs. C. ignore all except incremental amounts. D. ignore them in all cases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

46.

Which one of the following would not be expected to affect the decision of whether to undertake an investment? A. Income tax rates B. Estimates of future inflation rates C. Sales reductions in other products caused by this investment D. Cost of the feasibility study that was conducted for this project AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

47.

Which one of the following methods will provide a correct analysis for capital budgeting purposes? A. Discounting real cash flows with real rates. B. Discounting real cash flows with nominal rates. C. Discounting nominal cash flows with real rates. D. Discounting nominal cash flows with either real or nominal rates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

48.

The likely effect of discounting nominal cash flows with real interest rates will be to: A. make an investment's NPV appear more attractive. B. make an investment's NPV appear less attractive. C. correctly calculate an investment's NPV if inflation is expected. D. correctly calculate an investment's NPV, regardless of expected inflation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

49.

Your forecast shows $500,000 annually in sales for each of the next 3 years. If your second and third year predictions have failed to incorporate the 3% expected annual inflation, how far off in total dollar sales is your 3-year forecast? A. $45,450 B. $60,900 C. $52,550 D. $76,250 Difference = $500,000 + ($500,000 × 1.03) + ($500,000 × 1.03 2) − ($500,000 × 3) = $45,450

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Sales forecasts

50.

Which one of the following would be more apt to make an unacceptable project appear acceptable? A. Discounting real cash flows with real rates B. Discounting nominal cash flows with real rates C. Discounting real cash flows with nominal rates D. Discounting nominal cash flows with nominal rates AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

51.

Capital budgeting proposals should be evaluated as if the project were financed: A. entirely by debt. B. entirely by equity. C. half by debt and half by equity. D. with the highest cost source of funds, to be safe. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

52.

When calculating cash flow from operations, one should: A. subtract depreciation since it represents the cost of replacing worn-out equipment. B. deduct the depreciation tax shield from after-tax profit. C. use after-tax profit and ignore depreciation. D. add depreciation to after-tax profit. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Operating cash flow

53.

The recovery of an additional investment in working capital is likely to: A. occur at the end of a project's life. B. occur at the beginning of a project's life. C. occur whenever the project first shows a profit. D. be a sunk cost. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

54.

In what manner does depreciation expense affect investment projects? A. It reduces cash flows by the amount of the depreciation expense. B. It increases cash flows by the amount of the depreciation expense. C. It reduces taxable income by the amount of the depreciation expense. D. It reduces taxes by the amount of the depreciation expense. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

55.

Given a positive discount rate, which one of the following changes would increase the NPV of a project? A. Increasing the firm's opportunity cost of capital B. Reducing the amount of working capital that is needed. C. Spreading the total cash inflows over a longer time interval D. Increasing the project's estimated expenses AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

56.

What is the annual depreciation tax shield for a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense? A. $10,500 B. $30,000 C. $35,000 D. $65,000 Depreciation tax shield = $100,000 × 0.30 = $30,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

57.

What is the amount of the annual depreciation tax shield for a firm with $200,000 in net income, $75,000 in depreciation expense, and a 35% marginal tax rate? A. $26,250 B. $43,750 C. $70,000 D. $75,000 Depreciation tax shield = $75,000 × 0.35 = $26,250

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

58.

What is the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate? A. $260,000 B. $325,000 C. $360,000 D. $425,000 OCF = [$500,000 × (1 − 0.35)] + $100,000 = $425,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Operating cash flow

59.

A tax shield is equal to the reduction in a firm's: A. total tax liability resulting from a tax deductible expense. B. taxable income resulting from depreciation. C. taxable income resulting from a decrease in long-term debt. D. net income caused by depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

60.

Which one of the following categories would be least likely to require annual adjustments in a capital budgeting analysis due to the effects of inflation? A. Sales B. Expenses C. Working capital D. Depreciation expense AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

61.

Methods of accelerated depreciation: A. allow more total depreciation over the asset's life. B. decrease the depreciation tax shield. C. increase the depreciation tax shield. D. allow assets to be depreciated more rapidly. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

62.

Why is accelerated depreciation often favored for the corporation's set of tax books? A. It increases the total depreciation tax shield over the project's life. B. It reduces the total amount of taxes paid over the project's life. C. It increases net accounting profits over the project's life. D. It allows the depreciation tax savings to be realized earlier. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

63.

The modified accelerated cost recovery system (MACRS) allows an increase: A. in total depreciation over the asset's life. B. in annual depreciation during earlier years. C. in real but not nominal depreciation expense. D. in the asset's depreciable cost basis. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value.

Topic: Depreciation

64.

Under the MACRS: A. all assets are depreciated over 5 years. B. depreciable percentages decline throughout the asset's class life. C. straight-line depreciation percentages are doubled. D. assets are assumed to be purchased and sold midyear. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

65.

A firm plans to purchase a $50,000 asset that will be depreciated straight-line over a 5-year life to a zero salvage value. What is the present value of the resulting depreciation tax shield if the tax rate is 35% and the discount rate is 10%? A. $10,866.67 B. $13,267.75 C. $17,500.00 D. $37,908.18 Annual depreciation tax shield = $50,000 / 5 × 0.35 = $3,500 PV of tax shield = $3,500 {(1 / 0.1) − [1 / 0.1(1.1)5]} = $13,267.75

66.

The present value of the depreciation tax shield at any given discount rate is: A. equal for all depreciation methods. B. higher with MACRS than with straight-line depreciation. C. higher for the 7-year recovery period than for the 5-year recovery period class. D. likely to increase annually due to inflation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

67.

When the real rate of interest is less than the nominal rate of interest, then: A. disinflation must be occurring. B. investment returns cannot increase the purchasing power of an investment. C. nominal cash flows should be discounted with real rates. D. the rate of inflation must be positive. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

68.

When a depreciable asset is ultimately sold, the sales price is: A. fully taxable. B. nontaxable. C. nontaxable only if accelerated depreciation was used. D. taxable to the extent that the sales price exceeds book value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

69.

Which one of the following statements regarding depreciation is correct? A. The depreciation tax shield adjusts annually with the level of inflation. B. The real amount of annual depreciation is fixed, thus the higher the rate of inflation, the higher the depreciation tax shield. C. Tax law allows accelerated depreciation to be used for tax purposes. D. MACRS can be used for accounting purposes but not for tax purposes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

70.

The statement "We've got too much invested in that project to pull out now" possibly illustrates the need to: A. switch to an accelerated method of depreciation. B. recognize sunk costs. C. reduce net working capital assigned to the project. D. reduce discount rates to improve NPV. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project.

Topic: Project analysis and evaluation

71.

What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-tax cash flows from operations, $1,000 from the sale of a fully depreciated machine, a $2,000 investment in working capital, and a 35% tax rate? A. $8,450 B. $12,600 C. $12,650 D. $14,000 Cash flowFinal = $10,000 + $2,000 + $1,000 × (1 − 0.35) = $12,650

72.

At a 13% cost of capital, a project's NPV is $100,000 if you invest today. By what amount must the initial cost of the project decrease before you would wish to wait 2 years before investing? Assume all else is held constant. A. $21,685 B. $26,000 C. $27,690 D. $29,380 Required decrease = $100,000 × (1.13)2 − $100,000 = $27,690

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

73.

Which of the following correctly adjusts for depreciation when calculating a project’s operating cash flow? A. (revenues − cash expenses) × (1 − tax rate) + (tax rate × depreciation). B. pretax profit + depreciation tax shield. C. after-tax profit − depreciation. D. ignore depreciation since it is not a cash flow. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

74.

A new inventory system will immediately reduce inventory levels by $100,000. If this reduction is permanent and the cost of capital is 13%, how does the net working capital change affect company value? A. Company value increases by $100,000. B. NPV increases by $13,000. C. Company value will not change. D. Company value increases by $769,231. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

75.

The opportunity cost of a resource should be considered in project analysis, unless: A. negative cash flows result from its use. B. the resource was purchased in a prior time period. C. the resource has been fully depreciated. D. the resource has no identifiable market value or alternative use within the firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

76.

A new project requires an increase in both current assets and current liabilities of $125,000 each. What is the overall impact on the net working capital investment? A. An increase of zero B. An increase of $125,000 C. An increase of $250,000 D. An increase of $62,500, when averaged over the life of the project AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

77.

The primary difficulty in the allocation of overhead costs to prospective projects is that the: A. allocation will reduce the project's NPV. B. discount rate is unknown. C. costs may not represent an incremental expense. D. expenses may have been previously allocated. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium

Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

78.

If inflation is forecast to increase, which of the company’s following cash flows is most likely to change? A. The depreciation tax shield. B. Labor costs. C. Costs of raw materials purchased on a fixed price contract. D. Interest payments on its long-term debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

79.

A project costs $12,800 and is expected to provide a real cash inflow of $10,000 at the end of each of years 1 through 5. Calculate the net present value of this project if inflation is expected to be 4% in each year and the firm employs a nominal discount rate of 10.76%. A. $33,522.30 B. $28,756.79 C. $33,294.07 D. $26,311.15 Real rate = 1.1076 / 1.04 − 1 = 0.065 NPV = −$12,800 + $10,000{(1 / 0.065) − [1 / 0.065(1.065)5]} = $28,756.79

80.

An investment today of $25,000 promises to return $10,000 annually for the next 3 years. What is the real rate of return on this investment if inflation averages 6% annually during the period? A. 3.49% B. 9.78% C. 4.84% D. 6.38% Using a financial calculator: n = 3, PV = −$25,000, PMT = $10,000, FV = $0, CPT i/Y = 9.701% Real return = 1.09701 / 1.06 − 1 = 0.0349, or 3.49%

81.

What nominal annual return is required on an investment for an investor to experience a 12% gain in purchasing power? Assume inflation is 4%. A. 7.69% B. 9.29% C. 12.00% D. 16.48% Nominal rate = 1.12 × 1.04 − 1 = 0.1648, or 16.48%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

82.

What is the NPV of a 6-year project that costs $100,000, has annual revenues of $50,000 and costs of $15,000? Assume the investment can be depreciated for tax purposes straight-line over 6 years, the corporate tax rate is 35%, and the discount rate is 14%. A. −$15,560.04 B. $11,151.08 C. $3,411.14 D. $14,782.09 Annual cash flow = (revenues − costs) × (1 − tax rate) + (tax rate × depreciation) = (50,000 − 15,000) × (1 − 0.35) + (0.35 × 100,000 / 6) = $27,417 NPV = −$100,000 + $27,417 × [1 / 0.14 −1 / (0.14 × 1.14 6] = $11,151.08

83.

An investment of $120,000 can be depreciated for tax purposes straight line over 6 years. The corporate tax rate is 40%. When calculating cash flow: A. the company should deduct a depreciation tax shield of $8,000 a year from after-tax (revenues less cash expenses) B. the company should add a depreciation tax shield of $8,000 a year to after-tax (revenues less cash expenses) C. the company should add a depreciation tax shield of $20,000 a year to after-tax (revenues less cash expenses) D. no adjustment should be made for depreciation since it is not a cash expense. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-02 Calculate the cash flows of a project from standard financial statements. Topic: Operating cash flow

84.

A project that increased sales was accompanied by a $50,000 increase in inventory, a $20,000 increase in accounts receivable, and a $25,000 increase in accounts payable. Assuming these amounts remain constant, by how much has net working capital increased? A. $5,000 B. $25,000 C. $30,000 D. $45,000 ΔNWC = $50,000 + 20,000 − 25,000 = $45,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium

Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

85.

Which of the following costs probably should not be allocated to the investment needed for a new project? A. Project's required increase in accounts receivable B. New warehouse, built for this project C. A portion of the vice president's salary D. Labor expense for employees involved in the project AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Project analysis and evaluation

86.

A parcel of corporate land was recently chosen as the new plant site. What cost allocation should the land receive, based on the following: original cost of $200,000, highest market value during time of ownership of $300,000, net book value of $200,000, a recent offer to purchase for $250,000? A. $200,000 B. $250,000 C. $275,000 D. $300,000 AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

87.

Which of the following is true of the depreciation tax shield? A. It increases annually with the rate of inflation. B. It decreases annually in nominal terms. C. It is not altered by inflation. D. The real value of the depreciation is fixed. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

88.

Assuming an asset has been fully depreciated according to its MACRS class life, which one of the following statements is correct? A. Its market value is zero. B. Its book value is zero. C. Its book value is the current market value. D. It has neither a book value nor a market value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

89.

New projects can have multiple effects on a firm. Which one of the following appears to be a positive indirect effect? A. Additional working capital will be required at the start of the project. B. The sales force will need to be increased over the life of the project. C. Sales of replacement parts are expected in the future. D. The cost of employee benefits will increase due to new hires. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

90.

New projects or products can provide positive indirect effects as well as negative effects. Which one of the following appears to be a negative indirect effect? A. The new machine required for the project uses less electricity than the existing machine. B. Orders for your complementary products are expected to increase. C. Customer orders of supplies for the firm’s existing products are expected to decrease. D. Variable costs are expected to decrease since the firm can order larger quantities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

91.

Lew's Metals has a machine sitting idle in its warehouse. The machine originally cost $213,000, has a current book value of $32,300, has a scrap metal value of $13,000, and a market value of $46,900. The machine is totally paid for. What value should be placed on this machine if it is used for a new project? A. $0 B. $13,000 C. $32,300 D. $46,900 AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

92.

A project requires an additional commitment of $100,000 in net working capital in each of years 1 to 4. These extra investments can be recovered in year 5 when the project comes to an end. What is the effect on NPV? A. NPV is reduced by $100,000. B. NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for 4 years. C. NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for each of years 1 to 4 minus the discounted value of the $400,000 that is recovered in year 5. D. No opportunity cost is involved. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

93.

The additional inventory investment that is often required for new projects is partially offset by: A. switching to accelerated depreciation methods. B. reducing accounts receivable. C. decreasing equipment purchases. D. increasing accounts payable. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

94.

What rate of nominal growth is expected in sales if they are currently $1,000,000 and are expected to reach $1,600,000 in 5 years? Assume an inflation rate of 3.5%. A. 3.20% B. 9.86% C. 12.00% D. 26.49% ($1,600,000 / $1,000,000)1/5 − 1 = 9.86%

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

95.

What is the effect of using MACRS rather than straight-line depreciation? A. It increases the NPV. B. The total amount of depreciation is increased. C. It allows asset book values to increase with market values. D. It increases gross fixed assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

96.

In the MACRS depreciation schedules, the depreciation percentage is lower in the first year than in the second year. This is due to the fact that: A. the depreciation percentage increases every year over the project's life. B. assets are assumed to be acquired at midyear. C. depreciation expense increases at the rate of inflation. D. MACRS depreciation is less attractive than straight-line depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

97.

A firm invests $10 million in a new stamping machine. It depreciates it straight line for tax purposes over 5 years. The tax rate is 30%, inflation is 4% a year, and the discount rate is 8%. What is the PV of the depreciation tax shield? A. $600,000. B. $2,395,626. C. $2,579,497. D. $3,000,000. Annual depreciation tax shield = 0.3 × $10 million / 5 =$600,000 PV shield = $600,000{1 / 0.08 − 1 / (0.08 × 1.08 5)] = $2,395,626

98.

Capital budgeting projects typically assume that all cash flows transpire at the end of the year. The reason for this is that: A. less tax liability results from this practice. B. balance sheets are prepared at the end of the year. C. it simplifies the analysis and the resulting errors are usually small compared with the errors in forecasting future cash flows. D. most corporations collect their cash at the end of the year. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

99.

Which one of the following is not accurate in depicting the cash flows from operations for an all-equity firm? A. (revenues − cash expenses)(1 − tax rate) + (depreciation × tax rate) B. (revenues − expenses − taxes) C. (net profit + depreciation) D. (revenues − cash expenses − taxes) AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Operating cash flow

100.

Which of the following typically results from using straight-line depreciation rather than MACRS in the set of books for shareholders? A. Net income appears higher during the early periods of depreciation. B. Less money is paid to the Internal Revenue Service over an asset's life. C. Financial managers have more funds from operations available over the asset's life. D. Cash flow from operations will be higher in the second year of the asset's life. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

101.

When you evaluate a proposed project you should: A. allocate a percentage of current overhead costs to the project. B. include all indirect effects. C. include sunk costs. D. ignore opportunity costs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium

Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Cash flows

102.

Which one of the following formulas is incorrect? A. Operating cash flow = revenues − cash expenses − taxes B. Operating cash flow = net profit + depreciation C. Depreciation tax shield = depreciation × (1 − tax rate) D. Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (depreciation × tax rate) AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value. Topic: Depreciation

103.

Which one of these statements is incorrect? A. Real cash flows must be discounted at a real discount rate. B. (1 + real rate of interest) = (1 + nominal rate of interest) / (1 + inflation rate) C. The actual real rate of interest almost equals "nominal rate of interest − inflation rate." D. Inflation rate = nominal rate / real rate − 1 AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-01 Identify the cash flows from a proposed new project. Topic: Nominal and real rates

104.

Which of the following statements regarding investment in working capital is incorrect? A. An investment in working capital, unlike an investment in plant and equipment, represents a positive cash flow when the investment is made. B. Net working capital cash flow is measured by the change in working capital, not the level of working capital. C. Net working capital may change during the life of a project. D. Working capital is generally recovered at the end of a project. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 09-04 Understand how changes in working capital affect project cash flows. Topic: Net working capital

Chapter 09 Test bank - Static Summary Category AACSB: Analytical Thinking

# of Questions 18

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

104

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

104

Learning Objective: 09-01 Identify the cash flows from a proposed new project.

Learning Objective: 09-02 Calculate the cash flows of a project from standard financial statements.

Learning Objective: 09-03 Understand how the company's tax bill is affected by depreciation and how this affects project value.

Learning Objective: 09-04 Understand how changes in working capital affect project cash flows.

Topic: Cash flows

Topic: Depreciation

Topic: Fixed and variable costs

Topic: Income statement

Topic: Net working capital

Topic: Nominal and real rates

Topic: Operating cash flow

Topic: Pro forma statements

Topic: Project analysis and evaluation

Topic: Sales forecasts

Chapter 10 Test bank - Static Student: ___________________________________________________________________________

A capital budget shows a proposed list of investments. True

The strategic planning portion of the capital budgeting process is essentially a "bottom-up" process. True

False

Operating leverage increases with fixed cost. True

False

The degree of operating leverage (DOL) shows the relationship between sales and profits. True

False

The NPV break-even level of sales will be higher than the accounting break-even level. True

False

The level of sales that produces a zero project NPV is referred to as the accounting break-even point. True

False

While sensitivity analysis is forward-looking, scenario analysis attempts to reconstruct and analyze the past. True

False

Competitive advantage is an important element of many successful capital budgeting proposals. True

False

If a large proportion of a firm's costs is fixed, a shortfall in sales will have a magnified effect on the firm's profits. True

False

10. The greater the DOL, the greater the protection against operating losses during economic downturns. True

False

11. A firm that employs largely agency staff is likely to have higher operating leverage than one that employs its staff on long-term contracts. True

False

12. The option to abandon a project becomes more valuable as the possible outcomes become more varied. True

False

13. Conflicts of interest between shareholders and managers may result in the sacrifice of attractive capital budgeting proposals. True

False

14. Sensitivity analysis takes into consideration the interrelationship of variables. True

False

15. Scenario analysis allows managers to look at different and sometimes inconsistent combinations of variables. True

False

16. "What-if" questions ask what will happen to a project in various circumstances. True

False

17. What-if analysis is not crucial to capital budgeting. True

False

18. What-if analysis can help identify the inputs that are most worth refining before you commit to a project. True

False

19. The inputs that are most worth refining before you commit to a project are the ones that have the greatest potential to alter project NPV. True

False

20. Scenario analysis allows managers to look at different but consistent combinations of interrelated variables. True

False

21. A project that breaks even in accounting terms will surely have a negative NPV. True

False

22. A project that simply breaks even on an accounting basis gives you your money back but does not cover the opportunity cost of the capital tied up in the project. True

False

23. Managers that accept projects that only break even on an accounting basis are helping their shareholders. True

False

24. What level of management is responsible for originating capital budgeting proposals? A. Senior management B. Divisional management C. Lower management D. All levels of management

25. The capital budget should be consistent with the firm's: A. historical growth in sales. B. strategic plans. C. current level of debt. D. dividend policy. 26. Which one of the following would not be included as a traditional capital budgeting project? A. Machine replacement proposals B. Salary adjustment proposals C. New product proposals D. Plant expansion proposals 27. Which company is likely to have high operating leverage? A. A company with high fixed costs. B. A company with high variable costs. C. A company with low fixed costs. D. A company financed largely by debt 28. Which one of the following capital budgeting proposals is most apt to be associated with a conflict of interests? A. The proposal with the highest NPV B. The proposal with the longest payback period C. The proposal with the highest IRR and quickest payback D. The proposal to solve pollution problems cited by the EPA 29. Analysis indicates that a project's level of success is primarily dependent upon the firm controlling the variable costs. What type of analysis was conducted? A. Sensitivity analysis B. Break-even analysis C. Ratio analysis D. Real option analysis 30. Soft capital rationing may be beneficial to a firm if it: A. reduces a firm's taxes. B. weeds out proposals with NPVs that have been overstated. C. allows managers to select their favorite projects. D. lowers the cost of capital. 31. The purpose of sensitivity analysis is to show: A. the optimal level of capital expenditures. B. how price changes affect break-even volume. C. seasonal variation in product demand. D. how variables in a project affect profitability.

32. Sensitivity analysis evaluates projects by: A. forecasting changes in interest rates that would increase financing costs. B. recording profitability changes while changing one variable at a time. C. ensuring that the project sponsor has the proper incentives. D. testing for interrelated variables. 33. What is the change in the NPV of a one-year project if fixed costs are increased from $400 to $600, assuming the firm is profitable, has a 35% tax rate, and a 12% cost of capital? A. −$200.00 B. −$178.57 C. −$130.00 D. −$116.07 34. What happens to the NPV of a two-year project if sales less costs are increased in each year from $1,000 to $1,500? Assume the firm has a 35% tax rate, and a 15% cost of capital. A. NPV increases by $812.85. B. NPV increases by $528.36. C. NPV increases by $500.00. D. NPV increases by $282.61. 35. Which one of the following appears to be a more likely result from using sensitivity analysis? A. Agreement on the appropriate discount rate B. Determination of whether to finance with debt or equity C. Isolation of the pivotal factor in project profitability D. Selection of the best capital budgeting project 36. If a 20% reduction in a project’s forecast sales would still result in a positive NPV, then sensitivity analysis would suggest: A. that there is little point in further market research. B. that a more detailed sales forecast is required. C. that the initial sales forecasts were inflated. D. that more of the company’s overhead costs can be allocated to this product. 37. If sensitivity analysis concludes that the largest impact on profits would come from changes in the sales level, then: A. fixed costs should be traded for variable costs. B. variable costs should be traded for fixed costs. C. the project should not be undertaken. D. additional marketing analysis may be beneficial before proceeding. 38. Which one of the following statements is correct concerning sensitivity analysis? A. It ignores interrelationships between variables. B. Several variables are allowed to change concurrently. C. It considers all feasible variable combinations. D. It can guarantee a project's success.

39. Sensitivity analysis: A. makes most sense when variables are interrelated. B. gives an idea of the combined effect of pessimistic outcomes. C. allows the manager to weight the various outcomes to provide a better estimate of NPV. D. forces the manager to identify the underlying factors. 40. Which one of the following techniques may be more appropriate to analyze projects with interrelated variables? A. Sensitivity analysis B. Scenario analysis C. Break-even analysis D. DOL analysis 41. Which one of the following descriptions is representative of scenario analysis? A. One variable at a time is allowed to change. B. It isolates the unknowns that belong in the model. C. Different combinations of variables are analyzed. D. It represents the "top-down" approach. 42. Which statement is not correct? A. project proposers tend to be overconfident about the likely success of the project. B. project proposers often exaggerate the likely profitability in order to gain acceptance. C. overconfidence and enthusiasm can result in increased effort. D. most project proposals are based on very conservative forecasts. 43. Assume a 5-year project has a base-case NPV of $213,000, a tax rate of 34%, and a cost of capital of 14%. What will be the worst-case NPV if the annual after-tax cash flows are reduced in that scenario by $35,000 for each of the 5 years? A. −$92,842.17 B. −$120,157.83 C. $92,842.17 D. $120,157.83 44. Which one of the following variables would you suspect to be least significant in a sensitivity analysis of a fast-food establishment? A. Sales B. Depreciation C. Labor cost D. Food cost 45. A firm has fixed costs of $1.2 million and depreciation of $1 million. Variable costs are 64% of sales. What is the accounting break-even level of sales? A. $5.23 million B. $3.44 million C. $6.11 million D. $4.87 million

46. Weston's has variable costs that average 68% of sales. If fixed costs increase by $1, what will be the increase in the break-even level of revenues? A. An increase of $0.68 B. An increase of $1.00 C. An increase of $1.471 D. An increase of $3.125 47. The accounting break-even level of sales represents the point where: A. fixed costs are covered. B. variable costs are covered. C. fixed costs and variable costs are covered. D. sales are equal to the sum of fixed costs, variable costs, and depreciation. 48. The Corner Market has fixed costs of $1,600, depreciation of $1,200, a tax rate of 35%, and a cost of capital of 12%. Variable costs represent 67% of sales. What minimum level of sales must the market obtain to avoid a net loss on its income statement? A. $8,484.85 B. $6,666.67 C. $7,033.33 D. $7,867.67 49. Calculate the accounting break-even level of sales assuming $865,000 of fixed costs, $400,000 depreciation expense, and a variable costs-to-sales ratio of 65%. A. $2,769,230.77 B. $3,614,285.71 C. $4,237,769.23 D. $1,946.153.85 50. What effect will a reduction in the cost of capital have on the accounting break-even level of revenues? A. It raises the break-even level. B. It reduces the break-even level. C. It has no effect on the break-even level. D. This cannot be determined without knowing the length of the investment horizon. 51. Break-even revenues on an accounting basis typically indicate a: A. negative NPV. B. positive NPV. C. high degree of operating leverage. D. downturn in the business cycle. 52. The accounting break-even level of revenues represents the point at which the project has: A. zero pretax profit. B. zero net present value. C. covered all opportunity costs. D. covered the fixed and variable costs but not the depreciation.

53. Which one of the following changes might turn a negative NPV project into a positive NPV project? A. A decrease in the estimated annual sales B. An increase in the discount rate C. An increase in the initial investment D. A decrease in the fixed costs 54. If project sales exceed the accounting break-even point, but the project has a negative EVA, then the project has a: A. positive NPV but earns less than the discount rate. B. negative NPV but earns more than the discount rate. C. net loss on the income statement. D. net profit but negative NPV. 55. Calculate the ratio of variable costs to sales for a firm with a $3 million accounting break-even revenue point, $1.2 million fixed costs, and $450,000 depreciation. A. 40% B. 45% C. 55% D. 60% 56. What is the maximum percentage of variable costs to sales that a firm could have and still break even with $5 million in revenues, $1 million in fixed costs, and $500,000 of depreciation? A. 30% B. 70% C. 80% D. 90% 57. A firm with 60% of sales going to variable costs, $1.5 million fixed costs, and $500,000 depreciation and sales of $3 million. How does the current level of sales compare to the accounting break-even sales level? A. Current sales are $2 million below the break-even level. B. Current sales are $333,333 below the break-even level. C. Current sales are $800,000 below the break-even level. D. Current sales exceed the break-even level by $360,000. 58. A 6-year project has a zero NPV with sales of $5 million and a discount rate of 8%. The annual cash inflows are equal to 10% of sales minus $300,000. What was the initial investment in the project assuming that none of the investment is recoverable when the project ends? A. $416,667 B. $924,576 C. $1,016,678 D. $2,311,450

59. Calculate the NPV break-even level of sales for a project requiring an investment of $3 million and providing annual cash flows equal to 15% of sales less $250,000. None of the initial investment is recoverable. Assume the project will generate these cash flows for 10 years and the discount rate is 10%. A. $3,254,890 B. $3,504,890 C. $4,921,575 D. $1,686,667 60. If the level of sales is less than that calculated as the NPV break-even level, then the: A. project will break even in accounting terms. B. project's EVA will be greater than zero but less than the opportunity cost of capital. C. project will have a negative EVA. D. discount rate should be reduced. 61. One difference between an NPV break-even level of sales and an accounting break-even level of sales is the: A. consideration of the opportunity cost of capital. B. consideration of interest expense. C. allowance of the sales level to vary in response to changes in demand. D. inclusion of income taxes. 62. A project that has zero economic value added: A. has a positive NPV. B. has an NPV of zero. C. has a negative NPV. D. is at the accounting break-even point. 63. Which one of these projects would you always reject? A. High operating leverage, sales projected at the accounting break-even level, and no option to abandon or expand. B. High operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand. C. Low operating leverage, sales projected at the accounting break-even level, and an option to abandon or expand. D. Low operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand. 64. Fixed costs including depreciation have increased at Leverage Inc., from $4 million to $5.3 million. Suppose that the company now breaks even on an accounting basis with sales of $20 million. What must be the break-even variable cost as a percentage of sales? A. 69.2% B. 65.8% C. 73.5% D. 76.7%

65. Fixed costs: A. are a constant percentage of sales revenues. B. vary with the level of depreciation expense. C. are constant regardless of the level of output. D. are inversely related to the level of output. 66. A firm with high operating leverage is expected to: A. have high variable costs. B. have low fixed costs. C. have a high degree of profitability. D. perform particularly well when sales are high. 67. If the firm's degree of operating leverage is 4.5, what percentage change in sales will result in a 3% rise in profits? A. 0.33% B. 0.67% C. 3.03% D. 1.50% 68. If the firm's degree of operating leverage is 3.8, what percentage change in sales will result in a 13.8% fall in profits? A. 0.28% B. −2.75% C. −3.63% D. 10.00% 69. If the proportion of fixed costs increases: A. DOL falls. B. DOL rises. C. the NPVbreakeven level of sales declines. D. the NPV of the cash flows declines. 70. What happens to a firm with high operating leverage when the overall level of sales is very high? A. The firm is likely to have higher levels of fixed costs. B. The firm is likely to enjoy high profits. C. The firm will not break even in accounting terms. D. The firm will have a reduced level of depreciation. 71. For a firm with a DOL of 3.5, an increase in sales of 6% will: A. increase pretax profits by 3.5%. B. decrease pretax profits by 3.5%. C. increase pretax profits by 21.0%. D. increase pretax profits by 1.71%.

72. A firm with $800,000 of fixed costs including $200,000 of depreciation is expected to produce $225,000 in profits. What is its DOL? A. 3.56 B. 3.67 C. 4.56 D. 4.67 73. If a firm's DOL is 3.6 with a profit of $2,000,000 and depreciation of $500,000, what are its other fixed costs? A. $5,250,000 B. $4,700,000 C. $5,520,000 D. $5,800,000 74. A firm with a DOL of 4.5 generates pretax profits of $1 million. If depreciation expense is $600,000, what are its other fixed costs? A. $1.1 million B. $2.1 million C. $2.9 million D. $3.9 million 75. If a firm doubled its level of fixed costs but maintained its operating leverage, then one explanation may be that: A. depreciation expense increased to offset the increase. B. sales revenue also doubled and the proportion of variable costs did not change. C. sales revenues declined and the proportion of variable costs doubled. D. pretax profits decreased. 76. A project offers a 30% probability of a payoff after one year of $2 million and a 70% chance of a payoff of $1 million. What is the maximum you would invest in this project today if the discount rate is 10%? A. $818,181.82 B. $1,181,818.18 C. $1,300,000.00 D. $1,430,000.00 77. Decision trees: A. are an alternative to NPV analysis. B. recognize that managers may need to react to unexpected future events. C. are a way to adjust the discount rate to allow for uncertainty. D. lay out the different steps in preparing the capital budget.

78. If MacCaugh’s pilot project is successful, it will be able to build a plant with an NPV of $2 million in 1 year’s time. Otherwise the pilot investment will be valueless. If the discount rate is 20% and the chances of success are 50%, how much can MacCaugh afford to spend on the pilot project? A. $1 million. B. $2 million. C. $1.667 million. D. $833,333. 79. The branches on a decision tree A. illustrate possible combinations of fixed and variable costs. B. are a convenient way to illustrate the results of a sensitivity analysis. C. show possible project break-even points. D. show possible management decisions and possible uncertain consequences. 80. The option for a firm to expand future production has most value when: A. future production will be profitable. B. the outlook for the business is very assured. C. the future is very uncertain. D. today's production costs are lower than in the future. 81. The option to abandon a project inexpensively has particular value when: A. the equipment has a ready second-hand value. B. you can be confident about future profits. C. the project looks to have a very large NPV. D. has a low degree of operating leverage. 82. The option to switch between using oil or natural gas in a power station is: A. an option to expand. B. an option to abandon. C. a production flexibility option. D. a timing option. 83. A firm acquires a patent to produce a new enhanced type of transcripter. What is the real option? A. abandonment option. B. timing option. C. option to change raw material inputs. D. expansion option. 84. A firm has a tract of timber. The future growth rate of the trees and the price of lumber are uncertain. The firm: A. has an expansion option. B. has an option to vary the production technology. C. should harvest the timber immediately if NPV is positive. D. has a timing option.

85. Recognizing that it may be in managers' best interests to be overly optimistic when proposing projects, how might firms effectively control this impulse? A. Employ capital rationing B. Require that all proposals be initiated from the lowest possible management level C. Fire managers if any of their proposals fail to produce the expected results D. Fund all project proposals 86. One of the problems inherent in sensitivity analysis is that: A. it suggests when it may be useful to spend money to get a better estimate of sales or costs. B. most projects are equally sensitive to all variables. C. it ignores any interrelationships between variables. D. the cost of conducting the analysis is excessive. 87. Which of the following correctly describes sensitivity analysis? A. recalculation of project NPV by changing several inputs to new but consistent values. B. measures the degree to which fixed costs magnify the effect on profits of a shortfall in sales. C. analysis of how project NPV changes if different assumptions are made about key variables. D. measures the future level of sales at which NPV equals zero. 88. The accounting break-even point for a project is that level of sales where: A. sales revenue equals variable costs. B. sales revenue equals variable plus fixed costs. C. the operating cash flow equals zero. D. profit equals zero. 89. The greater the ratio of variable costs to sales, the: A. more each additional sale contributes to the coverage of fixed costs. B. lower the level of profitability. C. more units that must be sold to cover fixed charges. D. lower the benefit of conducting a sensitivity analysis. 90. When the level of fixed costs is decreased, the break-even level of revenues: A. will automatically decrease. B. will automatically increase. C. may or may not change, depending on variable costs. D. will remain unchanged as long as depreciation remains constant. 91. A manufacturer contemplates a change in technology that would reduce fixed costs from $800,000 to $600,000, and reduce depreciation expense from $125,000 to $100,000. However, the ratio of variable costs to sales would increase from 68% to 80%. What would be the change in the break-even level of revenues? A. Increase of $609,375 B. Increase of $574,750 C. Decrease of $211,250 D. Decrease of $341,675

92. In a graphic depiction of accounting break-even analysis, the greater the slope of the total cost line, the higher the: A. level of fixed costs. B. level of total revenue. C. number of units sold. D. percentage of variable costs to sales. 93. What is the economic break-even level of sales for a project costing $4,000,000 and generating annual cash flows equal to 0.30 × sales − $450,000? Assume the project will last 10 years and require a discount rate of 12%. A. $2,093,654 B. $2,359,047 C. $3,859,789 D. $13,783,333 94. The opportunity to abandon a project loses some of its value when: A. fixed costs are high. B. markets are extremely competitive. C. the future is relatively certain. D. secondary markets exist and are active. 95. Which one of the following sets of conditions represents the more suitable investment? A. Total revenues cover fixed and variable costs. B. An investment breaks even in an accounting sense. C. An investment breaks even in an economic sense. D. Total revenues exceed the costs of goods sold. 96. Positive NPV projects exist because: A. analysts select high discount rates. B. most projects are unique and innovative. C. cash-flow projections are extended into the future. D. firms hold competitive advantages. 97. How much depreciation expense exists in a firm that has a break-even level of revenues of $2 million, fixed costs of $400,000, and a 60% ratio of variable costs to sales? A. $144,000 B. $266,667 C. $400,000 D. $666,667 98. The accounting break-even point for a firm is a function of its: A. net cash flows and depreciation expense. B. fixed costs and gross profit on each sale. C. variable costs and tax rate. D. revenues and fixed costs.

99. What is the level of profits for a firm in which DOL = 5 and fixed costs including depreciation = $300,000? A. $60,000 B. $75,000 C. $1,200,000 D. $1,500,000 100. The DOL measures the percentage change in ______ given a percentage change in _____. A. fixed costs; sales B. profits; fixed costs C. profits; sales D. operating leverage; fixed costs 101. The economic break-even point of a project can be found by: A. setting the discount rate equal to the DOL. B. solving for the annual sales that will equate total revenue with total cost. C. solving for the annual sales that will give the project an NPV of zero. D. solving for the level of sales that will give the project an IRR of zero. 102. Firms that lack competitive advantages will: A. have difficulty finding positive NPV projects for investment. B. be forced to capture larger market shares to be profitable. C. avoid the need to conduct sensitivity analyses. D. be forced to operate with a high degree of operating leverage.

Chapter 10 Test bank - Static Key 1.

A capital budget shows a proposed list of investments. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Capital budgeting

The strategic planning portion of the capital budgeting process is essentially a "bottom-up" process. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Capital budgeting

Competitive advantage is an important element of many successful capital budgeting proposals. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Capital budgeting

While sensitivity analysis is forward-looking, scenario analysis attempts to reconstruct and analyze the past. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

The level of sales that produces a zero project NPV is referred to as the accounting break-even point. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium

Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

The NPV break-even level of sales will be higher than the accounting break-even level. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

The degree of operating leverage (DOL) shows the relationship between sales and profits. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

Operating leverage increases with fixed cost. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

If a large proportion of a firm's costs is fixed, a shortfall in sales will have a magnified effect on the firm's profits. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

10.

The greater the DOL, the greater the protection against operating losses during economic downturns. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

11.

A firm that employs largely agency staff is likely to have higher operating leverage than one that employs its staff on longterm contracts. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

12.

The option to abandon a project becomes more valuable as the possible outcomes become more varied. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Real options

13.

Conflicts of interest between shareholders and managers may result in the sacrifice of attractive capital budgeting proposals. TRUE AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Topic: Agency costs and problems

14.

Sensitivity analysis takes into consideration the interrelationship of variables. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

15.

Scenario analysis allows managers to look at different and sometimes inconsistent combinations of variables. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

16.

"What-if" questions ask what will happen to a project in various circumstances. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

17.

What-if analysis is not crucial to capital budgeting. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

18.

What-if analysis can help identify the inputs that are most worth refining before you commit to a project. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

19.

The inputs that are most worth refining before you commit to a project are the ones that have the greatest potential to alter project NPV. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

20.

Scenario analysis allows managers to look at different but consistent combinations of interrelated variables. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

21.

A project that breaks even in accounting terms will surely have a negative NPV. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

22.

A project that simply breaks even on an accounting basis gives you your money back but does not cover the opportunity cost of the capital tied up in the project. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

23.

Managers that accept projects that only break even on an accounting basis are helping their shareholders. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

24.

What level of management is responsible for originating capital budgeting proposals? A. Senior management B. Divisional management C. Lower management D. All levels of management AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Capital budgeting

25.

The capital budget should be consistent with the firm's: A. historical growth in sales. B. strategic plans. C. current level of debt. D. dividend policy. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Capital budgeting

26.

Which one of the following would not be included as a traditional capital budgeting project? A. Machine replacement proposals B. Salary adjustment proposals C. New product proposals D. Plant expansion proposals AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Capital budgeting

27.

Which company is likely to have high operating leverage? A. A company with high fixed costs. B. A company with high variable costs. C. A company with low fixed costs. D. A company financed largely by debt AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

28.

Which one of the following capital budgeting proposals is most apt to be associated with a conflict of interests? A. The proposal with the highest NPV B. The proposal with the longest payback period C. The proposal with the highest IRR and quickest payback D. The proposal to solve pollution problems cited by the EPA AACSB: Ethics Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Topic: Agency costs and problems

29.

Analysis indicates that a project's level of success is primarily dependent upon the firm controlling the variable costs. What type of analysis was conducted? A. Sensitivity analysis B. Break-even analysis C. Ratio analysis D. Real option analysis AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

30.

Soft capital rationing may be beneficial to a firm if it: A. reduces a firm's taxes. B. weeds out proposals with NPVs that have been overstated. C. allows managers to select their favorite projects. D. lowers the cost of capital. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Topic: Capital budgeting

31.

The purpose of sensitivity analysis is to show: A. the optimal level of capital expenditures. B. how price changes affect break-even volume. C. seasonal variation in product demand. D. how variables in a project affect profitability. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

32.

Sensitivity analysis evaluates projects by: A. forecasting changes in interest rates that would increase financing costs. B. recording profitability changes while changing one variable at a time. C. ensuring that the project sponsor has the proper incentives. D. testing for interrelated variables. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts.

Topic: Sensitivity analysis

33.

What is the change in the NPV of a one-year project if fixed costs are increased from $400 to $600, assuming the firm is profitable, has a 35% tax rate, and a 12% cost of capital? A. −$200.00 B. −$178.57 C. −$130.00 D. −$116.07 ΔNPV = (−$600 + 400)(1 − 0.35) / 1.12 = −$116.07

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

34.

What happens to the NPV of a two-year project if sales less costs are increased in each year from $1,000 to $1,500? Assume the firm has a 35% tax rate, and a 15% cost of capital. A. NPV increases by $812.85. B. NPV increases by $528.36. C. NPV increases by $500.00. D. NPV increases by $282.61. ΔNPV = 500(1 − 0.35) / 1.15 + 500(1 − 0.35) / 1.15 2 = $528.36

35.

Which one of the following appears to be a more likely result from using sensitivity analysis? A. Agreement on the appropriate discount rate B. Determination of whether to finance with debt or equity C. Isolation of the pivotal factor in project profitability D. Selection of the best capital budgeting project AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

36.

If a 20% reduction in a project’s forecast sales would still result in a positive NPV, then sensitivity analysis would suggest: A. that there is little point in further market research. B. that a more detailed sales forecast is required. C. that the initial sales forecasts were inflated. D. that more of the company’s overhead costs can be allocated to this product. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

37.

If sensitivity analysis concludes that the largest impact on profits would come from changes in the sales level, then: A. fixed costs should be traded for variable costs. B. variable costs should be traded for fixed costs. C. the project should not be undertaken. D. additional marketing analysis may be beneficial before proceeding. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

38.

Which one of the following statements is correct concerning sensitivity analysis? A. It ignores interrelationships between variables. B. Several variables are allowed to change concurrently. C. It considers all feasible variable combinations. D. It can guarantee a project's success. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

39.

Sensitivity analysis: A. makes most sense when variables are interrelated. B. gives an idea of the combined effect of pessimistic outcomes. C. allows the manager to weight the various outcomes to provide a better estimate of NPV. D. forces the manager to identify the underlying factors. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

40.

Which one of the following techniques may be more appropriate to analyze projects with interrelated variables? A. Sensitivity analysis B. Scenario analysis C. Break-even analysis D. DOL analysis AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

41.

Which one of the following descriptions is representative of scenario analysis? A. One variable at a time is allowed to change. B. It isolates the unknowns that belong in the model. C. Different combinations of variables are analyzed. D. It represents the "top-down" approach. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

42.

Which statement is not correct? A. project proposers tend to be overconfident about the likely success of the project. B. project proposers often exaggerate the likely profitability in order to gain acceptance. C. overconfidence and enthusiasm can result in increased effort. D. most project proposals are based on very conservative forecasts. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Topic: Simulation analysis

43.

Assume a 5-year project has a base-case NPV of $213,000, a tax rate of 34%, and a cost of capital of 14%. What will be the worst-case NPV if the annual after-tax cash flows are reduced in that scenario by $35,000 for each of the 5 years? A. −$92,842.17 B. −$120,157.83 C. $92,842.17 D. $120,157.83 NPV = $213,000 + (−$35,000 {(1 / 0.14) − [1 / 0.14(1.14 5)]}) = $92,842.17

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Scenario analysis

44.

Which one of the following variables would you suspect to be least significant in a sensitivity analysis of a fast-food establishment? A. Sales B. Depreciation C. Labor cost D. Food cost AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

45.

A firm has fixed costs of $1.2 million and depreciation of $1 million. Variable costs are 64% of sales. What is the accounting break-even level of sales? A. $5.23 million B. $3.44 million C. $6.11 million D. $4.87 million Profit margin = 1 − 0.64 = 0.36 Accounting B / E = ($1.2m + 1m) / 0.36 = $6.11 million

46.

Weston's has variable costs that average 68% of sales. If fixed costs increase by $1, what will be the increase in the breakeven level of revenues? A. An increase of $0.68 B. An increase of $1.00 C. An increase of $1.471 D. An increase of $3.125 ΔBreak-even revenues = $1 / (1 − 0.68) = $3.125

AACSB: Analytical Thinking

47.

The accounting break-even level of sales represents the point where: A. fixed costs are covered. B. variable costs are covered. C. fixed costs and variable costs are covered. D. sales are equal to the sum of fixed costs, variable costs, and depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

48.

The Corner Market has fixed costs of $1,600, depreciation of $1,200, a tax rate of 35%, and a cost of capital of 12%. Variable costs represent 67% of sales. What minimum level of sales must the market obtain to avoid a net loss on its income statement? A. $8,484.85 B. $6,666.67 C. $7,033.33 D. $7,867.67 Accounting B / E = ($1,600 + 1,200) / (1 − 0.67) = $8,484.85

49.

Calculate the accounting break-even level of sales assuming $865,000 of fixed costs, $400,000 depreciation expense, and a variable costs-to-sales ratio of 65%. A. $2,769,230.77 B. $3,614,285.71 C. $4,237,769.23 D. $1,946.153.85 Accounting B / E = ($865,000 + 400,000) / (1 − 0.65) = $3,614,285.71

Topic: Break-even analysis

50.

What effect will a reduction in the cost of capital have on the accounting break-even level of revenues? A. It raises the break-even level. B. It reduces the break-even level. C. It has no effect on the break-even level. D. This cannot be determined without knowing the length of the investment horizon. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

51.

Break-even revenues on an accounting basis typically indicate a: A. negative NPV. B. positive NPV. C. high degree of operating leverage. D. downturn in the business cycle. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

52.

The accounting break-even level of revenues represents the point at which the project has: A. zero pretax profit. B. zero net present value. C. covered all opportunity costs. D. covered the fixed and variable costs but not the depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

53.

Which one of the following changes might turn a negative NPV project into a positive NPV project? A. A decrease in the estimated annual sales B. An increase in the discount rate C. An increase in the initial investment D. A decrease in the fixed costs AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic

Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

54.

If project sales exceed the accounting break-even point, but the project has a negative EVA, then the project has a: A. positive NPV but earns less than the discount rate. B. negative NPV but earns more than the discount rate. C. net loss on the income statement. D. net profit but negative NPV. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

55.

Calculate the ratio of variable costs to sales for a firm with a $3 million accounting break-even revenue point, $1.2 million fixed costs, and $450,000 depreciation. A. 40% B. 45% C. 55% D. 60% Accounting B / E = $3m = ($1.2m + 0.45m) / x; x = 0.55 Variable costs to sales = 1 − 0.55 = 0.45, or 45%

56.

What is the maximum percentage of variable costs to sales that a firm could have and still break even with $5 million in revenues, $1 million in fixed costs, and $500,000 of depreciation? A. 30% B. 70% C. 80% D. 90% Accounting B / E = $5m = ($1m + 0.5m) / x; x = 0.30 Variable costs to sales = 1 − 0.30 = 0.70, or 70%

AACSB: Analytical Thinking

57.

A firm with 60% of sales going to variable costs, $1.5 million fixed costs, and $500,000 depreciation and sales of $3 million. How does the current level of sales compare to the accounting break-even sales level? A. Current sales are $2 million below the break-even level. B. Current sales are $333,333 below the break-even level. C. Current sales are $800,000 below the break-even level. D. Current sales exceed the break-even level by $360,000. Accounting B / E = ($1.5m + 0.5m) / (1 − 0.60) = $5m; Current sales are $2 million below the break-even level.

58.

A 6-year project has a zero NPV with sales of $5 million and a discount rate of 8%. The annual cash inflows are equal to 10% of sales minus $300,000. What was the initial investment in the project assuming that none of the investment is recoverable when the project ends? A. $416,667 B. $924,576 C. $1,016,678 D. $2,311,450 Investment = [($5m × 0.10) − $300,000]{(1 / 0.08) − [1 / 0.08(1.08 6)]} = $924,576

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

59.

Calculate the NPV break-even level of sales for a project requiring an investment of $3 million and providing annual cash flows equal to 15% of sales less $250,000. None of the initial investment is recoverable. Assume the project will generate these cash flows for 10 years and the discount rate is 10%. A. $3,254,890 B. $3,504,890 C. $4,921,575 D. $1,686,667 $3m = [(Sales × 0.15) − $250,000]{(1 / 0.10) − [1 / 0.10(1.10) 10]}; Sales = $4,921,575

60.

If the level of sales is less than that calculated as the NPV break-even level, then the: A. project will break even in accounting terms. B. project's EVA will be greater than zero but less than the opportunity cost of capital. C. project will have a negative EVA. D. discount rate should be reduced. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

61.

One difference between an NPV break-even level of sales and an accounting break-even level of sales is the: A. consideration of the opportunity cost of capital. B. consideration of interest expense. C. allowance of the sales level to vary in response to changes in demand. D. inclusion of income taxes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

62.

A project that has zero economic value added: A. has a positive NPV. B. has an NPV of zero. C. has a negative NPV. D. is at the accounting break-even point. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

63.

Which one of these projects would you always reject? A. High operating leverage, sales projected at the accounting break-even level, and no option to abandon or expand. B. High operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand. C. Low operating leverage, sales projected at the accounting break-even level, and an option to abandon or expand. D. Low operating leverage, sales projected at the NPV break-even level, and an option to abandon or expand. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Project analysis and evaluation

64.

Fixed costs including depreciation have increased at Leverage Inc., from $4 million to $5.3 million. Suppose that the company now breaks even on an accounting basis with sales of $20 million. What must be the break-even variable cost as a percentage of sales? A. 69.2% B. 65.8% C. 73.5% D. 76.7% Accounting B / E = $20m = $5.3m / (1 − x); x = 0.735, or 73.5%

65.

Fixed costs: A. are a constant percentage of sales revenues. B. vary with the level of depreciation expense. C. are constant regardless of the level of output. D. are inversely related to the level of output. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Fixed and variable costs

66.

A firm with high operating leverage is expected to: A. have high variable costs. B. have low fixed costs. C. have a high degree of profitability. D. perform particularly well when sales are high. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

67.

If the firm's degree of operating leverage is 4.5, what percentage change in sales will result in a 3% rise in profits? A. 0.33% B. 0.67% C. 3.03% D. 1.50% ΔSales = 3% / 4.5 = 0.67%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

68.

If the firm's degree of operating leverage is 3.8, what percentage change in sales will result in a 13.8% fall in profits? A. 0.28% B. −2.75% C. −3.63% D. 10.00% ΔSales = −13.8% / 3.8 = −3.63%

69.

If the proportion of fixed costs increases: A. DOL falls. B. DOL rises. C. the NPVbreakeven level of sales declines. D. the NPV of the cash flows declines. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

70.

What happens to a firm with high operating leverage when the overall level of sales is very high? A. The firm is likely to have higher levels of fixed costs. B. The firm is likely to enjoy high profits. C. The firm will not break even in accounting terms. D. The firm will have a reduced level of depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

71.

For a firm with a DOL of 3.5, an increase in sales of 6% will: A. increase pretax profits by 3.5%. B. decrease pretax profits by 3.5%. C. increase pretax profits by 21.0%. D. increase pretax profits by 1.71%. ΔProfits = 6% × 3.5 = 21%

72.

A firm with $800,000 of fixed costs including $200,000 of depreciation is expected to produce $225,000 in profits. What is its DOL? A. 3.56 B. 3.67 C. 4.56 D. 4.67 DOL = 1 + [$800,000 / $225,000] = 4.56

73.

If a firm's DOL is 3.6 with a profit of $2,000,000 and depreciation of $500,000, what are its other fixed costs? A. $5,250,000 B. $4,700,000 C. $5,520,000 D. $5,800,000 DOL = 3.6 = 1 + (FC + $500,000) / $2,000,000; FC = $4,700,000

74.

A firm with a DOL of 4.5 generates pretax profits of $1 million. If depreciation expense is $600,000, what are its other fixed costs? A. $1.1 million B. $2.1 million C. $2.9 million D. $3.9 million DOL= 4.5 = 1 + (FC + $600,000) / $1,000,000; FC = $2,900,000

75.

If a firm doubled its level of fixed costs but maintained its operating leverage, then one explanation may be that: A. depreciation expense increased to offset the increase. B. sales revenue also doubled and the proportion of variable costs did not change. C. sales revenues declined and the proportion of variable costs doubled. D. pretax profits decreased. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

76.

A project offers a 30% probability of a payoff after one year of $2 million and a 70% chance of a payoff of $1 million. What is the maximum you would invest in this project today if the discount rate is 10%? A. $818,181.82 B. $1,181,818.18 C. $1,300,000.00 D. $1,430,000.00 NPV = 0 = −Inv + [(0.30 × $2m) + (0.70 × $1m)] / 1.1; Inv = $1,181,818.18

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Decision trees

77.

Decision trees: A. are an alternative to NPV analysis. B. recognize that managers may need to react to unexpected future events. C. are a way to adjust the discount rate to allow for uncertainty. D. lay out the different steps in preparing the capital budget. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Decision trees

78.

If MacCaugh’s pilot project is successful, it will be able to build a plant with an NPV of $2 million in 1 year’s time. Otherwise the pilot investment will be valueless. If the discount rate is 20% and the chances of success are 50%, how much can MacCaugh afford to spend on the pilot project? A. $1 million. B. $2 million. C. $1.667 million. D. $833,333. NPV = 0 = C0 + 0.5 × $2 million / 1.2 C0 = −$833,333

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Decision trees

79.

The branches on a decision tree A. illustrate possible combinations of fixed and variable costs. B. are a convenient way to illustrate the results of a sensitivity analysis. C. show possible project break-even points. D. show possible management decisions and possible uncertain consequences. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Decision trees

80.

The option for a firm to expand future production has most value when: A. future production will be profitable. B. the outlook for the business is very assured. C. the future is very uncertain. D. today's production costs are lower than in the future. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Real options

81.

The option to abandon a project inexpensively has particular value when: A. the equipment has a ready second-hand value. B. you can be confident about future profits. C. the project looks to have a very large NPV. D. has a low degree of operating leverage. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Real options

82.

The option to switch between using oil or natural gas in a power station is: A. an option to expand. B. an option to abandon. C. a production flexibility option. D. a timing option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Real options

83.

A firm acquires a patent to produce a new enhanced type of transcripter. What is the real option? A. abandonment option. B. timing option. C. option to change raw material inputs. D. expansion option. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Real options

84.

A firm has a tract of timber. The future growth rate of the trees and the price of lumber are uncertain. The firm: A. has an expansion option. B. has an option to vary the production technology. C. should harvest the timber immediately if NPV is positive. D. has a timing option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Real options

85.

Recognizing that it may be in managers' best interests to be overly optimistic when proposing projects, how might firms effectively control this impulse? A. Employ capital rationing B. Require that all proposals be initiated from the lowest possible management level C. Fire managers if any of their proposals fail to produce the expected results D. Fund all project proposals AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects. Topic: Capital rationing

86.

One of the problems inherent in sensitivity analysis is that: A. it suggests when it may be useful to spend money to get a better estimate of sales or costs. B. most projects are equally sensitive to all variables. C. it ignores any interrelationships between variables. D. the cost of conducting the analysis is excessive. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

87.

Which of the following correctly describes sensitivity analysis? A. recalculation of project NPV by changing several inputs to new but consistent values. B. measures the degree to which fixed costs magnify the effect on profits of a shortfall in sales. C. analysis of how project NPV changes if different assumptions are made about key variables. D. measures the future level of sales at which NPV equals zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Sensitivity analysis

88.

The accounting break-even point for a project is that level of sales where: A. sales revenue equals variable costs. B. sales revenue equals variable plus fixed costs. C. the operating cash flow equals zero. D. profit equals zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

89.

The greater the ratio of variable costs to sales, the: A. more each additional sale contributes to the coverage of fixed costs. B. lower the level of profitability. C. more units that must be sold to cover fixed charges. D. lower the benefit of conducting a sensitivity analysis. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

90.

When the level of fixed costs is decreased, the break-even level of revenues: A. will automatically decrease. B. will automatically increase. C. may or may not change, depending on variable costs. D. will remain unchanged as long as depreciation remains constant. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

91.

A manufacturer contemplates a change in technology that would reduce fixed costs from $800,000 to $600,000, and reduce depreciation expense from $125,000 to $100,000. However, the ratio of variable costs to sales would increase from 68% to 80%. What would be the change in the break-even level of revenues? A. Increase of $609,375 B. Increase of $574,750 C. Decrease of $211,250 D. Decrease of $341,675 Accounting B / ECurrent = ($800,000 + 125,000) / (1 − 0.68) = $2,890,625 Accounting B / EProposed = ($600,000 + 100,000) / (1 − 0.80) = $3,500,000 ΔAccounting B / E = $3,500,000 − 2,890,625 = $609,375

92.

In a graphic depiction of accounting break-even analysis, the greater the slope of the total cost line, the higher the: A. level of fixed costs. B. level of total revenue. C. number of units sold. D. percentage of variable costs to sales. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

93.

What is the economic break-even level of sales for a project costing $4,000,000 and generating annual cash flows equal to 0.30 × sales − $450,000? Assume the project will last 10 years and require a discount rate of 12%. A. $2,093,654 B. $2,359,047 C. $3,859,789 D. $13,783,333 NPV = 0 = −$4,000,000 + [(0.30 × Sales) − $450,000] {(1 / 0.12) − [1 / 0.12(1.12 10)]}; Sales = $3,859,789

94.

The opportunity to abandon a project loses some of its value when: A. fixed costs are high. B. markets are extremely competitive. C. the future is relatively certain. D. secondary markets exist and are active. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting. Topic: Real options

95.

Which one of the following sets of conditions represents the more suitable investment? A. Total revenues cover fixed and variable costs. B. An investment breaks even in an accounting sense. C. An investment breaks even in an economic sense. D. Total revenues exceed the costs of goods sold. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

96.

Positive NPV projects exist because: A. analysts select high discount rates. B. most projects are unique and innovative. C. cash-flow projections are extended into the future. D. firms hold competitive advantages. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Project analysis and evaluation

97.

How much depreciation expense exists in a firm that has a break-even level of revenues of $2 million, fixed costs of $400,000, and a 60% ratio of variable costs to sales? A. $144,000 B. $266,667 C. $400,000 D. $666,667 $2,000,000 = ($400,000 + depreciation) / (1 − 0.60); Depreciation = $400,000

98.

The accounting break-even point for a firm is a function of its: A. net cash flows and depreciation expense. B. fixed costs and gross profit on each sale. C. variable costs and tax rate. D. revenues and fixed costs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

99.

What is the level of profits for a firm in which DOL = 5 and fixed costs including depreciation = $300,000? A. $60,000 B. $75,000 C. $1,200,000 D. $1,500,000 DOL = 5 = 1 + ($300,000 / profits); Profits = $75,000

100.

The DOL measures the percentage change in ______ given a percentage change in _____. A. fixed costs; sales B. profits; fixed costs C. profits; sales D. operating leverage; fixed costs AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage. Topic: Operating leverage

101.

The economic break-even point of a project can be found by: A. setting the discount rate equal to the DOL. B. solving for the annual sales that will equate total revenue with total cost. C. solving for the annual sales that will give the project an NPV of zero. D. solving for the level of sales that will give the project an IRR of zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-03 Use sensitivity, scenario, and break-even analyses to see how project profitability would be affected by an error in your forecasts. Topic: Break-even analysis

102.

Firms that lack competitive advantages will: A. have difficulty finding positive NPV projects for investment. B. be forced to capture larger market shares to be profitable. C. avoid the need to conduct sensitivity analyses. D. be forced to operate with a high degree of operating leverage. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 2 Medium Gradable: automatic Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths. Topic: Project analysis and evaluation

Chapter 10 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Ethics

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

102

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

102

Learning Objective: 10-01 Understand how companies organize the investment process so that it capitalizes on their strengths.

Learning Objective: 10-02 Appreciate the problems of obtaining unbiased inputs for valuing projects.

Learning Objective: 10-03 Use sensitivity, scenario, and breakeven analyses to see how project profitability would be affected by an error in your forecasts.

Learning Objective: 10-04 Understand why an overestimate of sales is more serious for projects with high operating leverage.

Learning Objective: 10-05 Recognize the importance of managerial flexibility in capital budgeting.

Topic: Agency costs and problems

Topic: Break-even analysis

Topic: Capital budgeting

Topic: Capital rationing

Topic: Decision trees

Topic: Fixed and variable costs

Topic: Operating leverage

Topic: Project analysis and evaluation

Topic: Real options

Topic: Scenario analysis

Topic: Sensitivity analysis

Topic: Simulation analysis

Chapter 11 Test bank - Static Student: ___________________________________________________________________________

A market index is used to measure performance of a broad-based portfolio of stocks. True

Stock market indexes are found in many countries outside the United States. True

False

The market risk premium is the difference between the return on common stocks and the risk-free interest rate. True

False

If one portfolio's variance exceeds that of another portfolio, its standard deviation will also be greater than that of the other portfolio. True

False

The expected return on an investment includes compensation for both the time value of money and the risks assumed. True

False

The S&P 500 accounts for most of the total market value of stocks traded in the United States. True

False

For investment horizons greater than 20 years, long-term bonds traditionally have outperformed common stocks. True

False

Long-term bonds are the only portfolio of securities found to be riskier than common stocks. True

False

Market risk can be eliminated in a stock portfolio through diversification. True

False

10. Macro risks are faced by all common stock investors. True

False

11. The risk that remains in a well-diversified stock portfolio is known as specific risk. True

False

12. Cyclical stocks tend to perform well when other stocks are performing well also. True

False

13. Average returns on high-risk assets are higher than those on low-risk assets. True

False

14. The historical record fails to show that investors have received a risk premium for holding risky assets. True

False

15. Many investors who bought shares of dot.com stocks in March 2000 saw the value of their investment decline over the next twoand-a-half years. True

False

16. Every additional stock added to a portfolio reduces the portfolio's level of risk by an equal amount. True

False

17. The expected return on an investment provides compensation to investors both for waiting and for worrying. True

False

18. One estimate of the market risk premium is provided by the difference between the average historical return on common stocks and the risk-free interest rate. True

False

19. When using historical data to estimate the market risk premium, it is important to focus on recent experience. True

False

20. A share of stock currently sells for $60, pays an annual dividend of $4.00, and earned a rate of return of 20% over the past year. What did this stock sell for one year ago? A. $42.00 B. $46.15 C. $48.46 D. $53.33 21. Sue purchased a stock for $25 a share, held it for one year, received a $1.34 dividend, and sold the stock for $26.45. What nominal rate of return did she earn? A. 11.16% B. 14.23% C. 12.09% D. 10.55% 22. What is the percentage return on a stock that was purchased for $48.40, paid a $1.67 dividend, and was then sold after one year for $46.20? A. −2.50% B. −1.10% C. 0.23% D. −0.33%

23. What was the percentage return on a non-dividend-paying stock that was purchased for $40.00 and then sold after one year for $39.00? A. −2.50% B. −0.39% C. −0.04% D. −2.56% 24. An investor receives a 15% total return by purchasing a stock for $40 and selling it after one year with a 5% capital gain. How much was received in dividend income during the year? A. $2.00 B. $2.20 C. $4.00 D. $4.40 25. How is it possible for real rates of return to increase during times when the rate of inflation increases? A. Inflation increased more than the real return. B. Nominal returns actually decreased. C. Nominal returns increased more than inflation. D. Nominal returns increased less than inflation. 26. What nominal return was received by an investor when inflation averaged 3.46% and the real rate of return was 2.5%? A. 0.96% B. 5.96% C. 6.05% D. 5.47% 27. Real rates of return are typically less than nominal rates of return due to: A. inflation. B. capital gains. C. dividend payments. D. depreciation. 28. If a share of stock provided a 14.84% nominal rate of return over the previous year while the real rate of return was 6.65%, then the inflation rate was: A. 8.89%. B. 7.68%. C. 8.03%. D. 9.12%. 29. The actual real rate of return on an investment will be positive as long as the: A. nominal return is positive. B. inflation rate is positive. C. nominal return exceeds the inflation rate. D. inflation rate exceeds the real return.

30. If inflation is 6%, what real rate of return is earned by an investor in a bond that was purchased for $1,000, has an annual coupon of 8%, and was sold at the end of the year for $960? A. −1.89% B. 1.92% C. −2.66% D. 2.47% 31. The Dow Jones Industrial Average is: A. the most representative of the stock market indexes. B. an index of 500 largest corporate stocks in America. C. an index of 30 major stocks. D. an equally weighted index of all stocks traded on the New York Stock Exchange. 32. "Dow up 14. Story at 6:00." This means that: A. the Dow was up 14% during today's trading. B. 14 of the Dow's 30 stocks increased in price today. C. a share of Dow stock went up by $14 today. D. the Dow index increased by 14 points in today's trading. 33. Although several stock indexes are available to inform investors of market changes, the Dow Jones Industrial Average: A. is the broadest-based of the market indexes. B. is the only reliable market index. C. accounts for approximately 90% of U.S. market value. D. is one of the best-known of the U.S. market indexes. 34. Risks that are peculiar to a single firm: A. are called market risks B. cannot be diversified away C. are called specific risks D. tend to cause stocks to move together 35. Stock A has 10 million shares outstanding and stock B has 5 million shares outstanding. Both stocks sell for $10 a share. What is their relative weighting if both stocks are represented in the S&P 500? A. They have equal weighting, like all S&P 500 stocks. B. B has twice the weighting, to account for having fewer shares. C. A has twice the weighting, to account for having more shares. D. They are weighted according to their expected performance. 36. Which one of these is the safest investment? A. Corporate bonds B. Common stock C. U.S. Treasury bills D. Preferred stock

37. Although Standard and Poor's Composite Index contains a limited number of U.S. publicly traded stocks, the Index represents: A. all stocks in the industrial sector. B. all stocks priced at $50 a share or more. C. approximately 40% of U.S. stocks traded, in market value. D. approximately 75% of U.S. stocks traded, in market value. 38. The primary difference between U.S. Treasury bills and U.S. Treasury bonds is that the bills: A. do not have default risk. B. have more price volatility. C. have a shorter maturity at time of issue. D. offer a higher return. 39. Assume market interest rates have risen substantially in the 5 years since an investor purchased Treasury bonds that were offering a 6% return over their 15-year life. If the investor sells now, he or she is likely to realize a total return that is: A. greater than 6%. B. less than 6%. C. equal to 2%. D. equal to 6%. 40. A maturity premium is offered on long-term Treasury bonds due to: A. the risk of changing interest rates. B. the risk of default. C. their specific risk. D. the uncertainty of their maturity date. 41. The idea that investors on average have earned a higher return from common stocks than from Treasury bills supports the view that: A. investors are irrational. B. there is a relationship between risk and return. C. real rates of return will be lower during periods of price stability. D. stocks should be avoided when inflation is low. 42. Which one of the following guarantees is offered to common stock investors? A. Guarantee to receive dividends B. Guarantee to receive capital gains C. Guarantee only to receive a refund of principal D. No guarantees of any form 43. The wider the dispersion of returns on a stock, the: A. lower the expected rate of return. B. higher the standard deviation. C. lower the real rate of return. D. lower the variance.

44. The variance of an investment's returns is a measure of the: A. volatility of the rates of return. B. probability of a negative return. C. historic return over long time periods. D. average value of the investment. 45. Which one of the following security classes has the highest standard deviation of returns? A. Common stocks B. Long-term Treasury bonds C. Treasury bills D. Corporate bonds 46. In a year in which common stocks offered an average return of 18% and Treasury bills offered 7%. The risk premium for common stocks was: A. 1%. B. 3%. C. 18%. D. 11%. 47. Over a 20-year period an investment of $1,000 in common stocks returned an average of 11% in nominal terms and 4% in real terms. At the end of the 20 years, the portfolio value was: A. $1,800 in real terms. B. $3,679.19 in real terms. C. $7,870.59 in nominal terms. D. $8,062.31 in nominal terms. 48. A stock is expected to return 11% in a normal economy, 19% if the economy booms, and lose 8% if the economy moves into a recessionary period. Economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock? A. 11.10% B. 12.06% C. 11.98% D. 11.23% 49. When the annual rate of return on U.S. Treasury bills is historically high, investors expect the return on the stock market: A. considerably lower than normal. B. about average. C. also to be high. D. approximately equal to zero.

50. Historical returns (1900-2015) suggest that in a year when Treasury bills offered 7.5 the approximate return on portfolio of common stocks should be in the region of: A. 7.5% B. 9.3% C. 15% D. 18.5% 51. The appropriate opportunity cost of capital is the return that investors give up on alternative investments that: A. possess the same level of risk. B. earn the risk-free rate of return. C. are included in the S&P 500 index. D. earn the average market rate of return. 52. An estimation of the opportunity cost of capital for projects that have an "average" level of risk is the expected rate of return on: A. Treasury bills. B. the market portfolio. C. the market portfolio minus the rate of return on Treasury bills. D. Treasury bonds plus a maturity premium. 53. Over the past 3 years an investment returned 18%, −12%, and 15%. What is the variance of returns? A. 231 B. 182 C. 546 D. 961 54. Over the past 4 years an investment returned 18%, −9%, −12%, and 15%. What is the standard deviation of returns? A. 9.2% B. 10.36% C. 11.2% D. 13.6% 55. The variance of a stock's returns can be calculated as the: A. average value of deviations from the mean. B. average value of squared deviations from the mean. C. square root of the average value of deviations from the mean. D. sum of the deviations from the mean.

56. Calculate the variance of returns for Alpha stock with the following historical rates of return: 2013 20% 2014 25% 2015 30% A. 16.67 B. 33.33 C. 50.00 D. 100.00 57. What is the standard deviation of returns of a portfolio that produced returns of 10%, 15%, 25%, and 30%? A. 7.9% B. 31.1% C. 62.5% D. 5.2% 58. What is the variance of returns of a portfolio that produced returns of 20%, 25%, and 30%, respectively? A. 10.00 B. 16.7 C. 15.00 D. 20.00 59. If the standard deviation of a portfolio's returns is known to be 30%, then its variance is: A. 5.48. B. 5.48 squared. C. 900.00 squared. D. 900.00 60. What is the standard deviation of a portfolio's returns if the mean return is 15%, and the variance of returns is 184? A. 7.83% B. 13.56% C. 41.00% D. 225.00% 61. What is the standard deviation of returns for an investment that is equally likely to return 100% as it is to provide a 100% loss? A. 0% B. 50% C. 71% D. 100%

62. What is the typical relationship between the standard deviation of an individual common stock and the standard deviation of a diversified portfolio of common stocks? A. The individual stock's standard deviation will be lower. B. The individual stock's standard deviation will be higher. C. The standard deviations should be equal. D. There is no relationship. 63. The standard deviations of individual stocks are generally higher than the standard deviation of the market portfolio because the market portfolio: A. offers lower returns. B. has less systematic risk. C. diversifies risk. D. has specific risk. 64. The benefits of portfolio diversification are highest when the individual securities within the portfolio have returns that: A. vary directly with the rest of the portfolio. B. vary proportionally with the rest of the portfolio. C. are largely uncorrelated with the rest of the portfolio. D. are perfectly correlated with the market portfolio. 65. The major benefit of diversification is the: A. increased expected return. B. removal of all negative risk assets from the portfolio. C. reduction in the portfolio's market risk. D. reduction in the portfolio's total risk. 66. Companies that are exposed to the business cycle: A. tend to have high market risk. B. tend to have low market risk. C. have negligible specific risk. D. are safe investments. 67. A firm is said to be countercyclical if its returns: A. continue to decrease, year after year. B. continue to increase, year after year. C. outperform when most stocks do poorly. D. are negative in real terms. 68. Industries that generally perform very well when the entire economy performs well and perform very badly when the economy performs badly are called: A. diversified industries. B. cyclical industries. C. risk-free industries. D. specific-risk industries.

69. What is the expected return on a portfolio that will decline in value by 13% in a recession, will increase by 16% in normal times, and will increase by 23% during boom times? Each scenario has an equal likelihood of occurrence. A. 8.67% B. 13.00% C. 13.43% D. 17.33% 70. The higher the standard deviation of a stock's returns, the: A. lower the level of specific risk. B. lower the expected rate of return. C. higher the accuracy of predictions of the stock's return for any given year. D. wider the dispersion of those returns over time. 71. The incremental risk to a portfolio from adding another stock: A. is always greater than the average portfolio risk. B. is always less than the average portfolio risk. C. is always positive. D. may be either positive or negative. 72. In general, which stocks should be combined into a portfolio if the goal is the greatest reduction possible in overall portfolio risk? A. Stocks with returns that are positively correlated B. Stocks with returns that are not correlated C. Stocks with returns that have the highest specific risk D. Stocks that have the highest expected returns 73. Which one of the following concerns is likely to be most important to portfolio investors seeking diversification? A. Total volatility of individual securities B. Standard deviation of individual securities C. Correlation of returns between securities D. Achieving the risk-free rate of return 74. A stock investor owns a diversified portfolio of 15 stocks. What will be the most likely effect on the portfolio's standard deviation if one more stock is added? A. A slight increase will occur. B. A large increase will occur. C. A slight decrease will occur. D. A large decrease will occur. 75. As you add more stocks to a portfolio: A. specific risk at first falls, then rises. B. market risk is increasingly diversified away. C. specific risk is increasingly diversified away. D. market risk declines but specific risk rises.

76. Risks that affect only a single firm are called: A. market risks. B. specific risks. C. systematic risks. D. risk premiums. 77. Which one of the following risks can be progressively eliminated by adding stocks to a portfolio? A. Systematic risk B. Specific risk C. Market risk D. Inflation rate risk 78. Which one of the following risks is most important to a well-diversified investor in common stocks? A. Market risk B. Specific risk C. Unsystematic risk D. Diversifiable risk 79. Which one of the following risks would be classified as a specific risk for an auto manufacturer? A. Interest rates B. Delays in launching a new model C. Business cycles D. Foreign exchange rates 80. Which statement is correct concerning macro risk exposure? A. All firms face equal macro risk exposure. B. Only portfolios of stocks face macro risk exposure. C. Macro risk exposure affects the cost of capital. D. Macro risk exposure is less important to diversified investors than micro risk exposure. 81. Individual stocks are: A. exposed to the same amount of market risk. B. exposed to differing amounts of market risk. C. not exposed to market risk; only the general economy is subject to market risk. D. exposed to differing amounts of market risk but the same amount of specific risk. 82. Which one of these is a specific risk? A. Revision to the corporate tax laws. B. Inflation increase of 2.3%. C. Deterioration in the overall economic outlook. D. A fire at the company’s main factory.

83. Which one of the following statements is incorrect concerning stock indexes? A. Indexes have been developed for foreign stocks. B. Some indexes cover only a specific market sector. C. Most indexes include all of the publicly-traded common stocks. D. Some indexes are equally weighted. 84. Periods of market decline are called: A. discount factors. B. bull markets. C. coupons. D. bear markets. 85. The fact that historical returns on Treasury bonds are less volatile than common stock returns indicates that: A. the variance of Treasury bond returns is zero. B. the standard deviation of Treasury bond returns is negative. C. the real return on Treasury bonds has been negative. D. common stocks should offer a higher return than Treasury bonds. 86. If the toss of a coin comes down heads, you win a dollar. If it comes down tails, you lose fifty cents. How much would you expect to gain after 20 tosses? A. $5.00 B. $7.50 C. $10.00 D. $15.00 87. A project's expected return is 15%, which represents a 35% return in a boom and a 5% return in a stagnant economy. What is the probability of a boom if these are the only two economic states? A. 18.33% B. 25.00% C. 33.33% D. 50.00% 88. What is the return to an investor who purchases a stock for $30, receives a $1.50 dividend at the end of the year, and then sells the share for $28.50? A. −5% B. 0% C. 5% D. 10% 89. Stock A has an expected return of 15%; stock B has an expected return of 8%. What is the expected return on a portfolio is comprised of 60% of Stock A and 40% of Stock B? A. 12.2% B. 10.8% C. 9.1% D. 14.4%

90. Which one of the following companies is most likely to be exposed to the least amount of macro risk? A. A producer of dog biscuits B. A regional airline C. A major commercial bank D. A machine tool manufacturer 91. An investor holds a stock for one year. She then receives a dividend of $10 and sells the stock for $120. If her return was 16%, at what price did she buy the stock? A. $103.45 B. $64.80 C. $139.20 D. $112.07 92. Which one of the following would you expect to represent the broadest-based index of U.S. stocks? A. Wilshire 5000 B. Dow Jones Industrial Average C. Standard and Poor's Composite D. Financial Times Index 93. Treasury bonds have provided a higher historical return than Treasury bills, which can be attributed to their: A. greater default risk. B. higher level of specific risk. C. greater exposure to interest rate risk. D. illiquidity. 94. Averaging the deviations from the mean for a portfolio of securities will: A. compute the standard deviation. B. compute the variance. C. equal zero. D. equal the number of securities in the portfolio. 95. One common reason for reporting standard deviations of percentage returns rather than variances is that standard deviations: A. are lower. B. are stated in understandable percentages. C. account properly for negative returns. D. take probability estimates into consideration. 96. When viewing the long-term trend of the price volatility of U.S. stocks, it is readily apparent that volatility has: A. continually increased. B. continually decreased. C. increased and decreased but has no specific pattern. D. remained constant for years.

97. If a stock's returns are volatile, then the stock: A. cannot be considered a negative risk asset. B. can still be considered a negative risk asset. C. has macro risk, but no specific risk. D. does not offer diversification potential. 98. A good way to reduce macro risk in a stock portfolio is to invest in stocks that: A. have only specific risks. B. have diversified away the macro risk. C. have low exposure to business cycles. D. pay guaranteed dividends. 99. Which one of the following firms is likely to exhibit the least macro risk exposure? A. Construction company B. Airline company C. Gold mining company D. Auto manufacturer 100. Investment risk can best be described as the: A. dispersion of possible returns. B. elimination of macro risk through diversification. C. possibility of changes in the cost of capital. D. level of systematic risk for an undiversified investor. 101. Since about 1900, the standard deviation of annual returns on a portfolio of U.S. common stocks has been about: A. −10%. B. 6%. C. 20%. D. 12%.

Chapter 11 Test bank - Static Key 1.

A market index is used to measure performance of a broad-based portfolio of stocks. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

Stock market indexes are found in many countries outside the United States. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

Long-term bonds are the only portfolio of securities found to be riskier than common stocks. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Historical performance

For investment horizons greater than 20 years, long-term bonds traditionally have outperformed common stocks. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Historical performance

The S&P 500 accounts for most of the total market value of stocks traded in the United States. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium

Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

The expected return on an investment includes compensation for both the time value of money and the risks assumed. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Expected (required) return

If one portfolio's variance exceeds that of another portfolio, its standard deviation will also be greater than that of the other portfolio. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

The market risk premium is the difference between the return on common stocks and the risk-free interest rate. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Risk Premium

Market risk can be eliminated in a stock portfolio through diversification. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Systematic and unsystematic risk

10.

Macro risks are faced by all common stock investors. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic

Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

11.

The risk that remains in a well-diversified stock portfolio is known as specific risk. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

12.

Cyclical stocks tend to perform well when other stocks are performing well also. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Asset classes

13.

Average returns on high-risk assets are higher than those on low-risk assets. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Risks and returns

14.

The historical record fails to show that investors have received a risk premium for holding risky assets. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Historical performance

15.

Many investors who bought shares of dot.com stocks in March 2000 saw the value of their investment decline over the next two-and-a-half years. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project.

Topic: Historical performance

16.

Every additional stock added to a portfolio reduces the portfolio's level of risk by an equal amount. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

17.

The expected return on an investment provides compensation to investors both for waiting and for worrying. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Expected (required) return

18.

One estimate of the market risk premium is provided by the difference between the average historical return on common stocks and the risk-free interest rate. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Risk Premium

19.

When using historical data to estimate the market risk premium, it is important to focus on recent experience. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Historical performance

20.

A share of stock currently sells for $60, pays an annual dividend of $4.00, and earned a rate of return of 20% over the past year. What did this stock sell for one year ago? A. $42.00 B. $46.15 C. $48.46 D. $53.33 0.20 = ($60 + 4 − P) / P; P = $53.33

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Total return

21.

Sue purchased a stock for $25 a share, held it for one year, received a $1.34 dividend, and sold the stock for $26.45. What nominal rate of return did she earn? A. 11.16% B. 14.23% C. 12.09% D. 10.55% R = ($26.45 + 1.34 − 25) / $25 = 0.1116, or 11.16%

22.

What is the percentage return on a stock that was purchased for $48.40, paid a $1.67 dividend, and was then sold after one year for $46.20? A. −2.50% B. −1.10% C. 0.23% D. −0.33% R = ($46.20 + 1.67 − 48.40) / $48.40 = −0.0110, or −1.10%

23.

What was the percentage return on a non-dividend-paying stock that was purchased for $40.00 and then sold after one year for $39.00? A. −2.50% B. −0.39% C. −0.04% D. −2.56% R = ($39 − 40) / $40 = −0.0250, or −2.50%

24.

An investor receives a 15% total return by purchasing a stock for $40 and selling it after one year with a 5% capital gain. How much was received in dividend income during the year? A. $2.00 B. $2.20 C. $4.00 D. $4.40 Dividend income = (0.15 − 0.05) × $40 = $4.00

25.

How is it possible for real rates of return to increase during times when the rate of inflation increases? A. Inflation increased more than the real return. B. Nominal returns actually decreased. C. Nominal returns increased more than inflation. D. Nominal returns increased less than inflation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Nominal and real returns

26.

What nominal return was received by an investor when inflation averaged 3.46% and the real rate of return was 2.5%? A. 0.96% B. 5.96% C. 6.05% D. 5.47% R = (1.0346 × 1.025) − 1 = 0.0605, or 6.05%

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Fisher effect

27.

Real rates of return are typically less than nominal rates of return due to: A. inflation. B. capital gains. C. dividend payments. D. depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Nominal and real returns

28.

If a share of stock provided a 14.84% nominal rate of return over the previous year while the real rate of return was 6.65%, then the inflation rate was: A. 8.89%. B. 7.68%. C. 8.03%. D. 9.12%. h = 1.1484 / 1.0665 − 1 = 0.0768, or 7.68%

29.

The actual real rate of return on an investment will be positive as long as the: A. nominal return is positive. B. inflation rate is positive. C. nominal return exceeds the inflation rate. D. inflation rate exceeds the real return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Nominal and real returns

30.

If inflation is 6%, what real rate of return is earned by an investor in a bond that was purchased for $1,000, has an annual coupon of 8%, and was sold at the end of the year for $960? A. −1.89% B. 1.92% C. −2.66% D. 2.47% Nominal return = [$960 + (0.08 × $1,000) − $1,000] / $1,000 = 0.04 Real return = 1.04 / 1.06 − 1 = −0.0189, or −1.89%

31.

The Dow Jones Industrial Average is: A. the most representative of the stock market indexes. B. an index of 500 largest corporate stocks in America. C. an index of 30 major stocks. D. an equally weighted index of all stocks traded on the New York Stock Exchange. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

32.

"Dow up 14. Story at 6:00." This means that: A. the Dow was up 14% during today's trading. B. 14 of the Dow's 30 stocks increased in price today. C. a share of Dow stock went up by $14 today. D. the Dow index increased by 14 points in today's trading. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

33.

Although several stock indexes are available to inform investors of market changes, the Dow Jones Industrial Average: A. is the broadest-based of the market indexes. B. is the only reliable market index. C. accounts for approximately 90% of U.S. market value. D. is one of the best-known of the U.S. market indexes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

34.

Risks that are peculiar to a single firm: A. are called market risks B. cannot be diversified away C. are called specific risks D. tend to cause stocks to move together AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Market and specific risk

35.

Stock A has 10 million shares outstanding and stock B has 5 million shares outstanding. Both stocks sell for $10 a share. What is their relative weighting if both stocks are represented in the S&P 500? A. They have equal weighting, like all S&P 500 stocks. B. B has twice the weighting, to account for having fewer shares. C. A has twice the weighting, to account for having more shares. D. They are weighted according to their expected performance. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project.

Topic: Stock market prices and reporting

36.

Which one of these is the safest investment? A. Corporate bonds B. Common stock C. U.S. Treasury bills D. Preferred stock AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Risks and returns

37.

Although Standard and Poor's Composite Index contains a limited number of U.S. publicly traded stocks, the Index represents: A. all stocks in the industrial sector. B. all stocks priced at $50 a share or more. C. approximately 40% of U.S. stocks traded, in market value. D. approximately 75% of U.S. stocks traded, in market value. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

38.

The primary difference between U.S. Treasury bills and U.S. Treasury bonds is that the bills: A. do not have default risk. B. have more price volatility. C. have a shorter maturity at time of issue. D. offer a higher return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Debt issues

39.

Assume market interest rates have risen substantially in the 5 years since an investor purchased Treasury bonds that were offering a 6% return over their 15-year life. If the investor sells now, he or she is likely to realize a total return that is: A. greater than 6%. B. less than 6%. C. equal to 2%. D. equal to 6%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Interest rate risk

40.

A maturity premium is offered on long-term Treasury bonds due to: A. the risk of changing interest rates. B. the risk of default. C. their specific risk. D. the uncertainty of their maturity date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Interest rate risk

41.

The idea that investors on average have earned a higher return from common stocks than from Treasury bills supports the view that: A. investors are irrational. B. there is a relationship between risk and return. C. real rates of return will be lower during periods of price stability. D. stocks should be avoided when inflation is low. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Risk and return relationship

42.

Which one of the following guarantees is offered to common stock investors? A. Guarantee to receive dividends B. Guarantee to receive capital gains C. Guarantee only to receive a refund of principal D. No guarantees of any form AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Common stock features

43.

The wider the dispersion of returns on a stock, the: A. lower the expected rate of return. B. higher the standard deviation. C. lower the real rate of return. D. lower the variance. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

44.

The variance of an investment's returns is a measure of the: A. volatility of the rates of return. B. probability of a negative return. C. historic return over long time periods. D. average value of the investment. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

45.

Which one of the following security classes has the highest standard deviation of returns? A. Common stocks B. Long-term Treasury bonds C. Treasury bills D. Corporate bonds AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

46.

In a year in which common stocks offered an average return of 18% and Treasury bills offered 7%. The risk premium for common stocks was: A. 1%. B. 3%. C. 18%. D. 11%. Risk premium = 18% − 7% = 11%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Risk Premium

47.

Over a 20-year period an investment of $1,000 in common stocks returned an average of 11% in nominal terms and 4% in real terms. At the end of the 20 years, the portfolio value was: A. $1,800 in real terms. B. $3,679.19 in real terms. C. $7,870.59 in nominal terms. D. $8,062.31 in nominal terms. FVNominal = $1,000(1.11)20 = $8,062.31 FVReal = $1,000(1.04)20 = $2,191.12

48.

A stock is expected to return 11% in a normal economy, 19% if the economy booms, and lose 8% if the economy moves into a recessionary period. Economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock? A. 11.10% B. 12.06% C. 11.98% D. 11.23% E(R) = (0.65 × 0.11) + (0.25 × 0.19) + (0.10 × −0.08) = 0.1110, or 11.10%

49.

When the annual rate of return on U.S. Treasury bills is historically high, investors expect the return on the stock market: A. considerably lower than normal. B. about average. C. also to be high. D. approximately equal to zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Expected (required) return

50.

Historical returns (1900-2015) suggest that in a year when Treasury bills offered 7.5 the approximate return on portfolio of common stocks should be in the region of: A. 7.5% B. 9.3% C. 15% D. 18.5% 7.5% + 7.6% (historical risk premium on common stocks) = 15.1%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Expected (required) return

51.

The appropriate opportunity cost of capital is the return that investors give up on alternative investments that: A. possess the same level of risk. B. earn the risk-free rate of return. C. are included in the S&P 500 index. D. earn the average market rate of return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Risks and returns

52.

An estimation of the opportunity cost of capital for projects that have an "average" level of risk is the expected rate of return on: A. Treasury bills. B. the market portfolio. C. the market portfolio minus the rate of return on Treasury bills. D. Treasury bonds plus a maturity premium. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Risks and returns

53.

Over the past 3 years an investment returned 18%, −12%, and 15%. What is the variance of returns? A. 231 B. 182 C. 546 D. 961 Mean = (18% − 12 + 15) / 3 = 7% Variance = {(18 − 7)2 + (−12 − 7)2 + (15 − 7)2} / 3 = 182

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

54.

Over the past 4 years an investment returned 18%, −9%, −12%, and 15%. What is the standard deviation of returns? A. 9.2% B. 10.36% C. 11.2% D. 13.6% Mean = (18% − 9 − 12 + 15) / 4 = 3% Variance = {[18 − 3]2 + [−9 − 3)2 + [−12 − 3)2 + [15 − 3)]2} / 4 = 184.5 Std dev = 184.50.5 = 13.6%

55.

The variance of a stock's returns can be calculated as the: A. average value of deviations from the mean. B. average value of squared deviations from the mean. C. square root of the average value of deviations from the mean. D. sum of the deviations from the mean. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

56.

Calculate the variance of returns for Alpha stock with the following historical rates of return: 2013 20% 2014 25% 2015 30% A. 16.67 B. 33.33 C. 50.00 D. 100.00 Mean = (20% + 25 + 30) / 3 = 25% Variance = {(20 − 25)2 + (25 − 25)2 + (30 − 25)2} / 3 = 16.67

57.

What is the standard deviation of returns of a portfolio that produced returns of 10%, 15%, 25%, and 30%? A. 7.9% B. 31.1% C. 62.5% D. 5.2% Mean = (10% + 15 + 25 + 30) / 4 = 20% Variance = {(10 − 20)2 + (15 − 20)2 + (25 − 20)2 + (30 − 20} / 4 = 62.5 Std dev = 62.50.5 = 7.9%

58.

What is the variance of returns of a portfolio that produced returns of 20%, 25%, and 30%, respectively? A. 10.00 B. 16.7 C. 15.00 D. 20.00 Mean = (20% + 25% + 30%) / 3 = 25% Variance = {(20 − 25)2 + (25 − 25)2 + (30 − 25)2} / 3= 16.7

59.

If the standard deviation of a portfolio's returns is known to be 30%, then its variance is: A. 5.48. B. 5.48 squared. C. 900.00 squared. D. 900.00 302 = 900

60.

What is the standard deviation of a portfolio's returns if the mean return is 15%, and the variance of returns is 184? A. 7.83% B. 13.56% C. 41.00% D. 225.00% Std dev = 1840.5 = 13.6%

Topic: Standard deviation and variance

61.

What is the standard deviation of returns for an investment that is equally likely to return 100% as it is to provide a 100% loss? A. 0% B. 50% C. 71% D. 100% Mean = 0.5 × 100% + 0.5 × −100% = 0% Variance = 0.5 × (100 − 0)2 + 0.5 × (−100 − 0)2 = 10,000 Std dev = 10,0000.5 = 100%

62.

What is the typical relationship between the standard deviation of an individual common stock and the standard deviation of a diversified portfolio of common stocks? A. The individual stock's standard deviation will be lower. B. The individual stock's standard deviation will be higher. C. The standard deviations should be equal. D. There is no relationship. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

63.

The standard deviations of individual stocks are generally higher than the standard deviation of the market portfolio because the market portfolio: A. offers lower returns. B. has less systematic risk. C. diversifies risk. D. has specific risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

64.

The benefits of portfolio diversification are highest when the individual securities within the portfolio have returns that: A. vary directly with the rest of the portfolio. B. vary proportionally with the rest of the portfolio. C. are largely uncorrelated with the rest of the portfolio. D. are perfectly correlated with the market portfolio. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

65.

The major benefit of diversification is the: A. increased expected return. B. removal of all negative risk assets from the portfolio. C. reduction in the portfolio's market risk. D. reduction in the portfolio's total risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

66.

Companies that are exposed to the business cycle: A. tend to have high market risk. B. tend to have low market risk. C. have negligible specific risk. D. are safe investments. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Classes of stock

67.

A firm is said to be countercyclical if its returns: A. continue to decrease, year after year. B. continue to increase, year after year. C. outperform when most stocks do poorly. D. are negative in real terms. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio.

Topic: Classes of stock

68.

Industries that generally perform very well when the entire economy performs well and perform very badly when the economy performs badly are called: A. diversified industries. B. cyclical industries. C. risk-free industries. D. specific-risk industries. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Classes of stock

69.

What is the expected return on a portfolio that will decline in value by 13% in a recession, will increase by 16% in normal times, and will increase by 23% during boom times? Each scenario has an equal likelihood of occurrence. A. 8.67% B. 13.00% C. 13.43% D. 17.33% E(R) = (−13% + 16 + 23) / 3 = 8.67%

70.

The higher the standard deviation of a stock's returns, the: A. lower the level of specific risk. B. lower the expected rate of return. C. higher the accuracy of predictions of the stock's return for any given year. D. wider the dispersion of those returns over time. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

71.

The incremental risk to a portfolio from adding another stock: A. is always greater than the average portfolio risk. B. is always less than the average portfolio risk. C. is always positive. D. may be either positive or negative. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

72.

In general, which stocks should be combined into a portfolio if the goal is the greatest reduction possible in overall portfolio risk? A. Stocks with returns that are positively correlated B. Stocks with returns that are not correlated C. Stocks with returns that have the highest specific risk D. Stocks that have the highest expected returns AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

73.

Which one of the following concerns is likely to be most important to portfolio investors seeking diversification? A. Total volatility of individual securities B. Standard deviation of individual securities C. Correlation of returns between securities D. Achieving the risk-free rate of return AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

74.

A stock investor owns a diversified portfolio of 15 stocks. What will be the most likely effect on the portfolio's standard deviation if one more stock is added? A. A slight increase will occur. B. A large increase will occur. C. A slight decrease will occur. D. A large decrease will occur. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

75.

As you add more stocks to a portfolio: A. specific risk at first falls, then rises. B. market risk is increasingly diversified away. C. specific risk is increasingly diversified away. D. market risk declines but specific risk rises. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

76.

Risks that affect only a single firm are called: A. market risks. B. specific risks. C. systematic risks. D. risk premiums. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

77.

Which one of the following risks can be progressively eliminated by adding stocks to a portfolio? A. Systematic risk B. Specific risk C. Market risk D. Inflation rate risk AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

78.

Which one of the following risks is most important to a well-diversified investor in common stocks? A. Market risk B. Specific risk C. Unsystematic risk D. Diversifiable risk AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

79.

Which one of the following risks would be classified as a specific risk for an auto manufacturer? A. Interest rates B. Delays in launching a new model C. Business cycles D. Foreign exchange rates AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

80.

Which statement is correct concerning macro risk exposure? A. All firms face equal macro risk exposure. B. Only portfolios of stocks face macro risk exposure. C. Macro risk exposure affects the cost of capital. D. Macro risk exposure is less important to diversified investors than micro risk exposure. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

81.

Individual stocks are: A. exposed to the same amount of market risk. B. exposed to differing amounts of market risk. C. not exposed to market risk; only the general economy is subject to market risk. D. exposed to differing amounts of market risk but the same amount of specific risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

82.

Which one of these is a specific risk? A. Revision to the corporate tax laws. B. Inflation increase of 2.3%. C. Deterioration in the overall economic outlook. D. A fire at the company’s main factory. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

83.

Which one of the following statements is incorrect concerning stock indexes? A. Indexes have been developed for foreign stocks. B. Some indexes cover only a specific market sector. C. Most indexes include all of the publicly-traded common stocks. D. Some indexes are equally weighted. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

84.

Periods of market decline are called: A. discount factors. B. bull markets. C. coupons. D. bear markets. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Historical performance

85.

The fact that historical returns on Treasury bonds are less volatile than common stock returns indicates that: A. the variance of Treasury bond returns is zero. B. the standard deviation of Treasury bond returns is negative. C. the real return on Treasury bonds has been negative. D. common stocks should offer a higher return than Treasury bonds. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Risks and returns

86.

If the toss of a coin comes down heads, you win a dollar. If it comes down tails, you lose fifty cents. How much would you expect to gain after 20 tosses? A. $5.00 B. $7.50 C. $10.00 D. $15.00 Expected return = 20 × [($1 × 0.5) − (0.50 × 0.5)] = $5.00

87.

A project's expected return is 15%, which represents a 35% return in a boom and a 5% return in a stagnant economy. What is the probability of a boom if these are the only two economic states? A. 18.33% B. 25.00% C. 33.33% D. 50.00% 15% = 35%(x) + 5%(1 − x); x = 33.33%

88.

What is the return to an investor who purchases a stock for $30, receives a $1.50 dividend at the end of the year, and then sells the share for $28.50? A. −5% B. 0% C. 5% D. 10% R = ($28.50 + 1.50 − 30) / $30 = 0%

89.

Stock A has an expected return of 15%; stock B has an expected return of 8%. What is the expected return on a portfolio is comprised of 60% of Stock A and 40% of Stock B? A. 12.2% B. 10.8% C. 9.1% D. 14.4% Portfolio: 0.6 × 15% + 0.4 × 8% = 12.2%

90.

Which one of the following companies is most likely to be exposed to the least amount of macro risk? A. A producer of dog biscuits B. A regional airline C. A major commercial bank D. A machine tool manufacturer AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot. Topic: Systematic and unsystematic risk

91.

An investor holds a stock for one year. She then receives a dividend of $10 and sells the stock for $120. If her return was 16%, at what price did she buy the stock? A. $103.45 B. $64.80 C. $139.20 D. $112.07 1.16 = ($120 + $10) / P; P = $112.07

92.

Which one of the following would you expect to represent the broadest-based index of U.S. stocks? A. Wilshire 5000 B. Dow Jones Industrial Average C. Standard and Poor's Composite D. Financial Times Index AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project. Topic: Stock market prices and reporting

93.

Treasury bonds have provided a higher historical return than Treasury bills, which can be attributed to their: A. greater default risk. B. higher level of specific risk. C. greater exposure to interest rate risk. D. illiquidity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Risks and returns

94.

Averaging the deviations from the mean for a portfolio of securities will: A. compute the standard deviation. B. compute the variance. C. equal zero. D. equal the number of securities in the portfolio. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

95.

One common reason for reporting standard deviations of percentage returns rather than variances is that standard deviations: A. are lower. B. are stated in understandable percentages. C. account properly for negative returns. D. take probability estimates into consideration. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Standard deviation and variance

96.

When viewing the long-term trend of the price volatility of U.S. stocks, it is readily apparent that volatility has: A. continually increased. B. continually decreased. C. increased and decreased but has no specific pattern. D. remained constant for years. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Historical performance

97.

If a stock's returns are volatile, then the stock: A. cannot be considered a negative risk asset. B. can still be considered a negative risk asset. C. has macro risk, but no specific risk. D. does not offer diversification potential. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

98.

A good way to reduce macro risk in a stock portfolio is to invest in stocks that: A. have only specific risks. B. have diversified away the macro risk. C. have low exposure to business cycles. D. pay guaranteed dividends. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-03 Understand why diversification reduces risk. Topic: Diversification concepts and measures

99.

Which one of the following firms is likely to exhibit the least macro risk exposure? A. Construction company B. Airline company C. Gold mining company D. Auto manufacturer AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot.

Topic: Systematic and unsystematic risk

100.

Investment risk can best be described as the: A. dispersion of possible returns. B. elimination of macro risk through diversification. C. possibility of changes in the cost of capital. D. level of systematic risk for an undiversified investor. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Risks and returns

101.

Since about 1900, the standard deviation of annual returns on a portfolio of U.S. common stocks has been about: A. −10%. B. 6%. C. 20%. D. 12%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio. Topic: Historical performance

Chapter 11 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

101

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

101

Learning Objective: 11-01 Estimate the opportunity cost of capital for an "average-risk" project.

Learning Objective: 11-02 Calculate returns and standard deviation of returns for individual common stocks or for a stock portfolio.

Learning Objective: 11-03 Understand why diversification reduces risk.

Learning Objective: 11-04 Distinguish between specific risk; which can be diversified away; and market risk; which cannot.

Topic: Asset classes

Topic: Classes of stock

Topic: Common stock features

Topic: Debt issues

Topic: Diversification concepts and measures

Topic: Expected (required) return

Topic: Expected return

Topic: Fisher effect

Topic: Historical performance

Topic: Interest rate risk

Topic: Market and specific risk

Topic: Nominal and real returns

Topic: Risk and return relationship

Topic: Risk Premium

Topic: Risks and returns

Topic: Standard deviation and variance

Topic: Stock market prices and reporting

Topic: Systematic and unsystematic risk

Topic: Total return

Chapter 12 Test bank - Static Student: ___________________________________________________________________________

The capital asset pricing model (CAPM) assumes that the stock market is dominated by well-diversified investors who are concerned only with market risk. True

The CAPM states that the expected risk premium on any security equals its beta times the market risk premium. True

False

Beta measures the total risk of an individual security. True

False

There is little doubt that the CAPM captures everything that is going on in the market. True

False

Empirical evidence suggests that over a long period of time returns are directly related to beta. True

False

The required risk premium for any given investment is defined by the security market line. True

False

The security market line sets a standard for other investments—investors will be willing to hold other investments only if they offer equally good prospects as shown by the points on the line. True

False

The security market line displays the relationship between expected return and beta. True

False

The security market line provides a standard that can be used to make project acceptance/rejection decisions. True

False

10. If a low-risk company invests in a high-risk project, those cash flows should be discounted at a high cost of capital. True

False

11. The project cost of capital depends on the risk of the company undertaking the project. True

False

12. Beta measures a stock's sensitivity to market risks. True

False

13. The project cost of capital depends on how the capital is used. True

False

14. Investors expect aggressive stocks to outperform the market in periods of strong economic activity. True

False

15. Defensive stocks typically provide better returns during periods of economic downturn since they are not very sensitive to market fluctuations. True

False

16. Diversification decreases the variability of both specific and market risk. True

False

17. Market risk premium is defined as the difference between the market rate of return and the risk-free interest rate. True

False

18. According to the CAPM, a stock's expected return is positively related to its beta. True

False

19. The CAPM is a theory of the relationship between risk and return that states that the expected risk premium on any security equals its beta times the market return. True

False

20. The stocks of gold-mining companies commonly have above-average volatility but relatively low betas. True

False

21. According to the capital asset pricing model, the expected rates of return for all projects lie on the security market line. True

False

22. As a project's beta increases, the project's opportunity cost of capital increases. True

False

23. A project should be accepted if its return plots below the security market line. True

False

24. The security market line shows how the expected rate of return depends on beta. True

False

25. The required risk premium for any investment is given by the security market line. True

False

26. Project cost of capital and company cost of capital are synonymous terms. True

False

27. The project cost of capital depends on the use to which that capital is put. Therefore, it depends on both the risk of the project and also on the risk of the company. True

False

28. If a company with a low credit rating invests in a low-risk project, it should discount the cash flows at a relatively high cost of capital. True

False

29. If a project has a risk of a bad outcome, the company should always set a higher discount rate to compensate. True

False

30. The expected return on a security includes a reward for: A. market risk and specific risk. B. specific risk. C. diversification and portfolio risk. D. time value of money and market risk. 31. If a security plots below the security market line, it is: A. ignoring all of the security's specific risk. B. underpriced, a situation that should be temporary. C. offering too little return to justify its risk. D. a defensive security, which expects to offer lower returns. 32. Macro events only are reflected in the performance of the market portfolio because: A. the market portfolio contains only risk-free securities. B. only macro events are tracked by economists. C. the specific risks have been diversified away. D. the firm-specific events would be too numerous to quantify. 33. In practice, the market portfolio is often represented by: A. a portfolio of U.S. Treasury securities. B. a diversified stock market index. C. an investor's mutual fund portfolio. D. the historic record of stock market returns.

34. A stock's beta measures the: A. average return on the stock. B. sensitivity of the stock's returns to those of the market portfolio. C. difference between the return on the stock and the return on the market portfolio. D. market risk premium on the stock. 35. In theory, the "market portfolio" should contain: A. the securities of the S&P 500. B. the securities of the Dow. C. the securities of the S&P 500 and Treasury bills. D. all risky assets. 36. When the overall market is up by 10%, investors with portfolios of defensive stocks will probably have: A. negative portfolio returns less than 10%. B. negative portfolio returns greater than 10%. C. positive portfolio returns less than 10%. D. positive portfolio returns greater than 10%. 37. When the overall market experiences a decline of 8%, investors with portfolios of aggressive stocks will probably experience portfolio: A. losses of less than 8%. B. losses greater than 8%. C. gains of less than 8%. D. gains greater than 8%. 38. A stock with a beta greater than 1.0 would be termed: A. an aggressive stock, expected to increase more than the market increases. B. a defensive stock, expected to decrease more than the market increases. C. an aggressive stock, expected to decrease more than the market increases. D. a defensive stock, expected to increase more than the market decreases. 39. The average of the betas for all stocks is: A. greater than 1.0; most stocks are aggressive. B. less than 1.0; most stocks are defensive. C. unknown; betas are continually changing. D. exactly 1.0; these stocks represent the market. 40. The slope of the line fitted to a plot of a stock's returns versus the market's returns measures the: A. security market line. B. beta of the stock. C. market risk premium. D. capital asset pricing model.

41. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2%, then its beta equals: A. 1.04. B. 1.24. C. 1.33. D. 1.40. 42. If the slope of the line measuring a stock's returns against the market's returns is positive, then the stock: A. has a beta greater than 1.0. B. has no specific risk. C. has a positive beta. D. plots above the security market line. 43. If the line measuring a stock's historic returns against the market's historic returns has a slope greater than 1.0, then the: A. stock is currently underpriced. B. market risk premium is increasing. C. stock has a significant amount of specific risk. D. stock has a beta exceeding 1.0. 44. What is the most likely explanation for a +20.0% return on a stock with a beta of 1.0 in a month when the market returned +10.0%? A. The stock is aggressive. B. The market is undervalued. C. Favorable firm-specific news was reported. D. The beta is really less than 1.0. 45. If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then, a priori, we could expect this individual stock to: A. lose more than 10%. B. lose, but less than 10%. C. gain more than 10%. D. gain, but less than 10%. 46. A stock’s total risk depends on the stock's _________ and __________. A. beta; specific risk B. beta; market risk C. specific risk; firm-specific risk D. aggressive risk; defensive risk 47. Estimate a stock's beta based on the following information: Month 1 = Stock + 1.5%, Market + 1.1%; Month 2 = Stock + 2.0%, Market + 1.4%; Month 3 = Stock − 2.5%, Market − 2.0%. A. Greater than 1.0 B. Less than 1.0 C. Equal to 1.0 D. Indeterminate

48. If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be more profitable to invest in: A. high beta stocks. B. low beta stocks. C. stocks with large amounts of specific risk. D. stocks that plot above the security market line. 49. What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73? A. 1.0 B. 1.17 C. 1.22 D. 1.25 50. You want to construct a portfolio containing equal amounts of U.S. Treasury bills and two stocks. If the beta of the first stock is 1.23 and the beta of the portfolio is 1.0, what does the beta of the second stock have to be? A. 0.77 B. 1.23 C. 0.23 D. 1.77 51. An investor wishes to invest equal amounts in three stocks and to achieve a portfolio beta of 1.2. If stock A has a beta of 0.9 and stock B has a beta of 1.1, what must be the beta of stock C? A. 0.7 B. 1.6 C. 1.2 D. 1.8 52. What is the standard deviation of the market portfolio if the standard deviation of a well-diversified portfolio with a beta of 1.25 equals 20%? A. 16.00% B. 18.75% C. 25.00% D. 32.50% 53. What is the beta of a U.S. Treasury bill? A. 1.0 B. −1.0 C. 0 D. Unknown

54. One of the easiest methods of diversifying away firm-specific risks is to: A. buy only stocks with a beta of 1.0. B. build a portfolio with 40 to 55 individual stocks. C. purchase the shares of an index fund. D. purchase stocks that plot above the security market line. 55. A scatter in the plot of a stock’s returns versus the returns on the market reflects the: A. high beta of the stock. B. specific risk of the stock. C. changes in market risk premium over time. D. current underpricing of the stock. 56. A project has a beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is 9.2%. What is the project's expected rate of return? A. 15.21% B. 11.41% C. 10.50% D. 14.61% 57. A project has a beta of 0.97, the risk-free rate is 4.1%, and the market risk premium is 8.1%. What is the project's expected rate of return? A. 7.98% B. 11.96% C. 8.35% D. 11.83% 58. Which one of the following statements is correct when Treasury bills yield 7.5% and the market risk premium is 9.5%? A. The S&P 500 would be expected to return 8.50%. B. The S&P 500 would be expected to return 9.50%. C. The S&P 500 would be expected to return 12.68%. D. The S&P 500 would be expected to return 17.00%. 59. If a well-diversified portfolio of stocks has an expected return of 25% when the expected return on the market portfolio is 15%, then A. Treasury bills are offering a 10% yield. B. The portfolio beta is greater than 1.0. C. The portfolio beta equals 1.67. D. The investor's portfolio contains many defensive stocks. 60. The market rate of return is 12.5% and the risk-free rate is 3.1%. What will be the change in a stock's expected rate of return if its beta increases from 1.2 to 1.4? A. 1.88% B. 2.5% C. 18.8% D. 25.0%

61. If a stock with a beta of 1.4 is expected to return 18% when Treasury bills yield 6%, what is the expected return on the market portfolio? A. 8.67% B. 10.84% C. 12.02% D. 14.57% 62. When Treasury bills yield 7% and the expected return on the market is 16%, then the risk premium on an asset is equal to: A. 9%. B. 16%. C. 9% times the asset's beta. D. 9% plus the risk-free rate. 63. Calculate the risk premium on stock C given the following information: risk-free rate = 5%, market return = 13%, stock C’s beta = 1.3. A. 8.0% B. 10.4% C. 15.4% D. 16.9% 64. If the interest rate on Treasury bills is 6% and the market risk premium is 9%, then a stock with a beta of 1.5 would be expected to return: A. 12.0%. B. 17.0%. C. 19.5%. D. 21.5%. 65. An investor expects a return of 18% on his portfolio with a beta of 1.25. If the expected market risk premium increases from 8% to 10%, what return should he now expect on the portfolio? A. 20.0% B. 20.5% C. 22.5% D. 26.0% 66. An investor expects a return of 14.7% on her portfolio with a beta of 1.13. If the expected market risk premium decreases from 8% to 7%, what return should she now expect on the portfolio? A. 13.57% B. 13.89% C. 14.67% D. 15.87%

67. What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is expected to yield 14% and Treasury bills offer 6%? A. 9.2% B. 11.2% C. 12.4% D. 12.8% 68. You believe that Alpha stock which has a beta of 1.32 will return 16.0% this coming year. The market is expected to return 11.4% and T-bills return 3.8%. According to CAPM, which one of these statements is correct given this information? A. The stock is currently underpriced. B. The stock plots below the security market line. C. The risk premium on the stock is too low given the stock's beta. D. The stock plots to the left of the market on a security market line graph. 69. Why should stock market investors ignore specific risks when calculating required rates of return? A. There is no method for quantifying specific risks. B. Specific can be diversified away. C. Specific risks are compensated by the risk-free rate. D. Beta includes a component to compensate for specific risk. 70. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio beta is: A. 0.70. B. 1.05. C. 1.40. D. 2.10. 71. A portfolio consists of an index mutual fund which represents the overall market and Treasury bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is 7.6%. What is your best estimate of the portfolio expected rate of return? A. 8.39% B. 7.76% C. 10.80% D. 9.02% 72. What is the beta of a security with an expected return of 12% if Treasury bills yield 6% and the market risk premium is 8%? A. 0.50 B. 0.75 C. 0.90 D. 1.50 73. The slope of the security market line equals: A. one. B. beta. C. the market risk premium. D. the expected return on the market portfolio.

74. A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the market rate of return is 10.6%? A. 2.825% B. 3.250% C. 3.275% D. 3.415% 75. The market portfolio has an expected return of 18% and the risk-free rate is 6%. An investor borrows $100 at the risk-free rate and invests this and a further $100 of his own in the market portfolio. What is his expected return? A. 18.6% B. 19.6% C. 21.6% D. 30.0% 76. If Stock A has a higher expected return than Stock B, which of the following statements is most likely? A. Stock A has more specific risk. B. Stock B plots below the security market line. C. Stock B is a cyclical stock. D. Stock A has a higher beta. 77. A stock's risk premium is equal to the: A. expected market return times beta. B. Treasury bill yield plus the expected market return. C. risk-free rate plus the expected market risk premium. D. expected market risk premium times beta. 78. Investing borrowed funds in a stock portfolio will generally: A. increase the beta of the portfolio. B. decrease the volatility of the portfolio. C. decrease the expected return on the portfolio. D. increase the market risk premium. 79. A stock is expected to pay a year-end dividend of $8 and then to sell at a price of $109. The risk-free interest rate is 4%, the expected market return is 12% and the stock has a beta of 0.8. What is the stock price today? A. $102.99. B. $98.73. C. $105.98. D. $109.00. 80. Which one of these statements is correct? A. Betas can be measured exactly. B. If a stock has a very low beta, it is likely to have a high beta in the future. C. The expected future risk premium is easy to accurately determine. D. CAPM is widely used as a means of estimating expected returns.

81. What happens to the expected portfolio return if the portfolio beta increases from 1.0 to 1.5, the risk-free rate decreases from 5 to 4%, and the market risk premium increases from 8 to 9%? A. It increases from 12 to 14.0%. B. It increases from 13 to 17.5%. C. It increases from 12 to 12.5%. D. It increases from 13 to 13.5%. 82. What would you recommend to an investor who is considering an investment that plots below the security market line? A. Invest; The expected return is high relative to the risk. B. Don't invest; The risk is high relative to the expected return. C. Invest; All stocks revert to the SML over time. D. Don't invest; All stocks below the SML are low-growth stocks. 83. Investment projects that plot above the security market line have: A. a positive NPV. B. a negative NPV. C. a zero NPV. D. an excessively high discount rate. 84. The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if: A. it results in a negative NPV for the proposal. B. the project has a different degree of risk from the company. C. the company has specific risk. D. the company expects to earn more than the risk-free rate. 85. A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable. A. company cost of capital B. risk-free rate C. market risk premium D. project cost of capital 86. A project with higher than average risk offers an expected return of 14%. Which statement is correct if the company's opportunity cost of capital is 12% and the project's opportunity cost of capital is 15%? A. Project NPV is positive; it should be accepted. B. Project NPV is negative; it should be rejected. C. Project NPV is positive but it should be rejected. D. Project NPV is negative but it should be accepted. 87. The project cost of capital is: A. equal to the company cost of capital. B. less than the company cost of capital. C. greater than the company cost of capital because the project has specific risk. D. not necessarily related to the company cost of capital.

88. The minimum acceptable expected rate of return on a project is the: A. project cost of capital. B. company cost of capital. C. risk-free rate of return. D. project beta times the market risk premium. 89. If changing discount rates from the company cost of capital to the project cost of capital changes NPV from negative to positive, then the project should use the: A. company cost of capital and be accepted. B. company cost of capital and be rejected. C. project cost of capital and be accepted. D. project cost of capital and be rejected. 90. Which one of the following statements best explains the fact that cyclical firms tend to have high betas? A. Their earnings are particularly sensitive to the state of the economy. B. Their stocks are overpriced. C. Their earnings are less diversifiable. D. Their profit margins are small. 91. What type of risk is properly reflected in a project's discount rate? A. Market risk B. Specific risk C. Total risk D. Diversifiable risk 92. Last month a stock with a beta of 1.0 lost 20% while the S&P 500 had a 10% gain. Given this, it is most likely that the: A. stock's beta has been calculated incorrectly. B. S&P 500 cannot represent the overall market. C. firm released some negative information about itself. D. the market index had an exceptionally good month. 93. The slope of the fitted line that shows the relationship between a stock's return and the market's return is the: A. market's beta. B. stock's beta. C. market risk premium. D. stock's standard deviation. 94. Which one of the following is most likely correct for a diversified stock portfolio that exhibits a higher standard deviation than the market index? A. The portfolio contains aggressive stocks with a beta greater than 1.0 B. The portfolio plots below the security market line. C. The portfolio's beta is less than 1.0. D. The portfolio contains a significant amount of specific risk.

95. An investor divides her portfolio into three equal parts, with one part in Treasury bills, one part in a market index, and one part in a mutual fund with beta of 1.50. What is the beta of the investor's overall portfolio? A. 0.83 B. 1.00 C. 1.17 D. 1.25 96. If the market portfolio is expected to return 16%, then a portfolio that is expected to return 13%: A. plots above the security market line. B. plots to the right of the market on an SML graph. C. is not diversified. D. has a beta that is less than 1.0. 97. The basic tenet of the CAPM is that a stock's expected risk premium should be: A. greater than the expected market return. B. proportionate to the market return. C. proportionate to the stock's beta. D. greater than the risk-free rate of return. 98. If the company cost of capital is 20% and a proposed project's cost of capital is 15%, then discounting the projects' cash flows at 20% would: A. determine where the project plots in relation to the security market line. B. make the project look more attractive than it should be. C. be correct from a theoretical perspective. D. be incorrect and could cause the project to be erroneously rejected. 99. Over the long run value stocks have: A. had low ratios of book value to market value. B. performed exactly as predicted by CAPM. C. provided a higher return than growth stocks. D. consistently underperformed. 100. If a project could have a bad outcome: A. the discount rate should be increased. B. expected cash flows should be adjusted downward to reflect this possibility. C. the beta should be increased. D. the market risk premium should be revised downward. 101. A project costs $3 million, and is expected to generate $1 million in cash flows for the next 4. If the opportunity cost of capital is 15%, the project’s return would plot: A. above the security market line. B. below the security market line. C. on the security market line. D. on the security market line, with a beta of 1.0.

102. An investor prefers to invest in companies that have high operating leverage. How can this be accomplished if the investor also requires a portfolio beta of 1.0? A. Invest 50% in cyclical stocks and 50% in firms with high operating leverage B. Invest 50% in a market index fund and 50% in firms with high operating leverage C. Finance part of the portfolio with borrowing D. Invest a portion of the portfolio in U.S. Treasury securities 103. Which one of the following portfolios might be expected to exhibit less specific risk? A. Five random stocks; portfolio beta = 0.8 B. Three random stocks; portfolio beta = 1.2 C. Ten random stocks; portfolio beta = 1.0 D. Twelve random stocks; portfolio beta unknown 104. If the plot of a portfolio's returns against returns on the market index produces a tight pattern, then the portfolio: A. appears to be well diversified. B. has a beta of 0. C. has very little systematic risk. D. has a risk premium lower than the market. 105. If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then the investor should expect to receive: A. the risk-free rate plus 75% of the expected return on the market. B. the risk-free rate plus 75% of the expected market risk premium. C. 75% of the expected return on the market. D. 25% of the risk-free rate plus 75% of the expected market risk premium. 106. Which statement is correct? A. the superior performance of value stocks is exactly what the CAPM would predict. B. the CAPM predicts that investors are concerned only with the risk that cannot be diversified away. C. few financial managers in practice use the CAPM to estimate the cost of capital. D. the CAPM is a model of actual returns whereas the cost of capital is concerned with expected returns.

Chapter 12 Test bank - Static Key 1.

The capital asset pricing model (CAPM) assumes that the stock market is dominated by well-diversified investors who are concerned only with market risk. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

The CAPM states that the expected risk premium on any security equals its beta times the market risk premium. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

The security market line displays the relationship between expected return and beta. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

The security market line sets a standard for other investments—investors will be willing to hold other investments only if they offer equally good prospects as shown by the points on the line. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Security market line

The required risk premium for any given investment is defined by the security market line. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Security market line

Empirical evidence suggests that over a long period of time returns are directly related to beta. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

There is little doubt that the CAPM captures everything that is going on in the market. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

Beta measures the total risk of an individual security. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

The security market line provides a standard that can be used to make project acceptance/rejection decisions. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Security market line

10.

If a low-risk company invests in a high-risk project, those cash flows should be discounted at a high cost of capital. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

11.

The project cost of capital depends on the risk of the company undertaking the project. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

12.

Beta measures a stock's sensitivity to market risks. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

13.

The project cost of capital depends on how the capital is used. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

14.

Investors expect aggressive stocks to outperform the market in periods of strong economic activity. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

15.

Defensive stocks typically provide better returns during periods of economic downturn since they are not very sensitive to market fluctuations. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.

Topic: Security market line

16.

Diversification decreases the variability of both specific and market risk. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Diversification concepts and measures

17.

Market risk premium is defined as the difference between the market rate of return and the risk-free interest rate. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

18.

According to the CAPM, a stock's expected return is positively related to its beta. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

19.

The CAPM is a theory of the relationship between risk and return that states that the expected risk premium on any security equals its beta times the market return. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

20.

The stocks of gold-mining companies commonly have above-average volatility but relatively low betas. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Systematic and unsystematic risk

21.

According to the capital asset pricing model, the expected rates of return for all projects lie on the security market line. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

22.

As a project's beta increases, the project's opportunity cost of capital increases. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Security market line

23.

A project should be accepted if its return plots below the security market line. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Security market line

24.

The security market line shows how the expected rate of return depends on beta. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

25.

The required risk premium for any investment is given by the security market line. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Security market line

26.

Project cost of capital and company cost of capital are synonymous terms. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Cost of capital-general

27.

The project cost of capital depends on the use to which that capital is put. Therefore, it depends on both the risk of the project and also on the risk of the company. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Cost of capital-general

28.

If a company with a low credit rating invests in a low-risk project, it should discount the cash flows at a relatively high cost of capital. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Cost of capital-general

29.

If a project has a risk of a bad outcome, the company should always set a higher discount rate to compensate. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

30.

The expected return on a security includes a reward for: A. market risk and specific risk. B. specific risk. C. diversification and portfolio risk. D. time value of money and market risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

31.

If a security plots below the security market line, it is: A. ignoring all of the security's specific risk. B. underpriced, a situation that should be temporary. C. offering too little return to justify its risk. D. a defensive security, which expects to offer lower returns. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

32.

Macro events only are reflected in the performance of the market portfolio because: A. the market portfolio contains only risk-free securities. B. only macro events are tracked by economists. C. the specific risks have been diversified away. D. the firm-specific events would be too numerous to quantify. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Diversification concepts and measures

33.

In practice, the market portfolio is often represented by: A. a portfolio of U.S. Treasury securities. B. a diversified stock market index. C. an investor's mutual fund portfolio. D. the historic record of stock market returns. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

34.

A stock's beta measures the: A. average return on the stock. B. sensitivity of the stock's returns to those of the market portfolio. C. difference between the return on the stock and the return on the market portfolio. D. market risk premium on the stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

35.

In theory, the "market portfolio" should contain: A. the securities of the S&P 500. B. the securities of the Dow. C. the securities of the S&P 500 and Treasury bills. D. all risky assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

36.

When the overall market is up by 10%, investors with portfolios of defensive stocks will probably have: A. negative portfolio returns less than 10%. B. negative portfolio returns greater than 10%. C. positive portfolio returns less than 10%. D. positive portfolio returns greater than 10%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

37.

When the overall market experiences a decline of 8%, investors with portfolios of aggressive stocks will probably experience portfolio: A. losses of less than 8%. B. losses greater than 8%. C. gains of less than 8%. D. gains greater than 8%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

38.

A stock with a beta greater than 1.0 would be termed: A. an aggressive stock, expected to increase more than the market increases. B. a defensive stock, expected to decrease more than the market increases. C. an aggressive stock, expected to decrease more than the market increases. D. a defensive stock, expected to increase more than the market decreases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

39.

The average of the betas for all stocks is: A. greater than 1.0; most stocks are aggressive. B. less than 1.0; most stocks are defensive. C. unknown; betas are continually changing. D. exactly 1.0; these stocks represent the market. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

40.

The slope of the line fitted to a plot of a stock's returns versus the market's returns measures the: A. security market line. B. beta of the stock. C. market risk premium. D. capital asset pricing model. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

41.

If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2%, then its beta equals: A. 1.04. B. 1.24. C. 1.33. D. 1.40. β = 1.6% / 1.2% = 1.33

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze

Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

42.

If the slope of the line measuring a stock's returns against the market's returns is positive, then the stock: A. has a beta greater than 1.0. B. has no specific risk. C. has a positive beta. D. plots above the security market line. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

43.

If the line measuring a stock's historic returns against the market's historic returns has a slope greater than 1.0, then the: A. stock is currently underpriced. B. market risk premium is increasing. C. stock has a significant amount of specific risk. D. stock has a beta exceeding 1.0. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

44.

What is the most likely explanation for a +20.0% return on a stock with a beta of 1.0 in a month when the market returned +10.0%? A. The stock is aggressive. B. The market is undervalued. C. Favorable firm-specific news was reported. D. The beta is really less than 1.0. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

45.

If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then, a priori, we could expect this individual stock to: A. lose more than 10%. B. lose, but less than 10%. C. gain more than 10%. D. gain, but less than 10%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

46.

A stock’s total risk depends on the stock's _________ and __________. A. beta; specific risk B. beta; market risk C. specific risk; firm-specific risk D. aggressive risk; defensive risk AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Stock returns and yields

47.

Estimate a stock's beta based on the following information: Month 1 = Stock + 1.5%, Market + 1.1%; Month 2 = Stock + 2.0%, Market + 1.4%; Month 3 = Stock − 2.5%, Market − 2.0%. A. Greater than 1.0 B. Less than 1.0 C. Equal to 1.0 D. Indeterminate AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

48.

If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be more profitable to invest in: A. high beta stocks. B. low beta stocks. C. stocks with large amounts of specific risk. D. stocks that plot above the security market line. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

49.

What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73? A. 1.0 B. 1.17 C. 1.22 D. 1.25 βPortfolio = 0.25 × 0.9 + 0.4 × 1.05 + 0.35 × 1.73 = 1.25

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

50.

You want to construct a portfolio containing equal amounts of U.S. Treasury bills and two stocks. If the beta of the first stock is 1.23 and the beta of the portfolio is 1.0, what does the beta of the second stock have to be? A. 0.77 B. 1.23 C. 0.23 D. 1.77 1 = (0 + 1.23 + βB) / 3; βB = 1.77

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

51.

An investor wishes to invest equal amounts in three stocks and to achieve a portfolio beta of 1.2. If stock A has a beta of 0.9 and stock B has a beta of 1.1, what must be the beta of stock C? A. 0.7 B. 1.6 C. 1.2 D. 1.8 1.2 = (0.9 + 1.1 + βC) / 3; βC = 1.6

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium

Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

52.

What is the standard deviation of the market portfolio if the standard deviation of a well-diversified portfolio with a beta of 1.25 equals 20%? A. 16.00% B. 18.75% C. 25.00% D. 32.50% Portfolio σ = beta × market portfolio σ 20% = 1.25 × σm σm = 16%

53.

What is the beta of a U.S. Treasury bill? A. 1.0 B. −1.0 C. 0 D. Unknown AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

54.

One of the easiest methods of diversifying away firm-specific risks is to: A. buy only stocks with a beta of 1.0. B. build a portfolio with 40 to 55 individual stocks. C. purchase the shares of an index fund. D. purchase stocks that plot above the security market line. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Diversification concepts and measures

55.

A scatter in the plot of a stock’s returns versus the returns on the market reflects the: A. high beta of the stock. B. specific risk of the stock. C. changes in market risk premium over time. D. current underpricing of the stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

56.

A project has a beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is 9.2%. What is the project's expected rate of return? A. 15.21% B. 11.41% C. 10.50% D. 14.61% E(R) = 3.8% + 1.24(9.2% − 3.8) = 10.50%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

57.

A project has a beta of 0.97, the risk-free rate is 4.1%, and the market risk premium is 8.1%. What is the project's expected rate of return? A. 7.98% B. 11.96% C. 8.35% D. 11.83% E(R) = 4.1% + 0.97(8.1%) = 11.96%

58.

Which one of the following statements is correct when Treasury bills yield 7.5% and the market risk premium is 9.5%? A. The S&P 500 would be expected to return 8.50%. B. The S&P 500 would be expected to return 9.50%. C. The S&P 500 would be expected to return 12.68%. D. The S&P 500 would be expected to return 17.00%. E(R) = 7.5% + 1(9.5%) = 17%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

59.

If a well-diversified portfolio of stocks has an expected return of 25% when the expected return on the market portfolio is 15%, then A. Treasury bills are offering a 10% yield. B. The portfolio beta is greater than 1.0. C. The portfolio beta equals 1.67. D. The investor's portfolio contains many defensive stocks. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

60.

The market rate of return is 12.5% and the risk-free rate is 3.1%. What will be the change in a stock's expected rate of return if its beta increases from 1.2 to 1.4? A. 1.88% B. 2.5% C. 18.8% D. 25.0% ΔE(R) = (1.4 − 1.2)(12.5% − 3.1%) = 0.19%

61.

If a stock with a beta of 1.4 is expected to return 18% when Treasury bills yield 6%, what is the expected return on the market portfolio? A. 8.67% B. 10.84% C. 12.02% D. 14.57% 18% = 6% + 1.4(rm − 6%); rm = 14.57%

62.

When Treasury bills yield 7% and the expected return on the market is 16%, then the risk premium on an asset is equal to: A. 9%. B. 16%. C. 9% times the asset's beta. D. 9% plus the risk-free rate. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

63.

Calculate the risk premium on stock C given the following information: risk-free rate = 5%, market return = 13%, stock C’s beta = 1.3. A. 8.0% B. 10.4% C. 15.4% D. 16.9% RPC = 1.3(13% − 5) = 10.4%

64.

If the interest rate on Treasury bills is 6% and the market risk premium is 9%, then a stock with a beta of 1.5 would be expected to return: A. 12.0%. B. 17.0%. C. 19.5%. D. 21.5%. E(R) = 6% + 1.5(9%) = 19.5%

65.

An investor expects a return of 18% on his portfolio with a beta of 1.25. If the expected market risk premium increases from 8% to 10%, what return should he now expect on the portfolio? A. 20.0% B. 20.5% C. 22.5% D. 26.0% E(R) = 18% + 1.25(10% − 8%) = 20.5%

66.

An investor expects a return of 14.7% on her portfolio with a beta of 1.13. If the expected market risk premium decreases from 8% to 7%, what return should she now expect on the portfolio? A. 13.57% B. 13.89% C. 14.67% D. 15.87% E(R) = 14.7% + 1.13(7% − 8%) = 13.57%

67.

What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is expected to yield 14% and Treasury bills offer 6%? A. 9.2% B. 11.2% C. 12.4% D. 12.8% E(R) = 6% + 0.8(14% − 6) = 12.4%

68.

You believe that Alpha stock which has a beta of 1.32 will return 16.0% this coming year. The market is expected to return 11.4% and T-bills return 3.8%. According to CAPM, which one of these statements is correct given this information? A. The stock is currently underpriced. B. The stock plots below the security market line. C. The risk premium on the stock is too low given the stock's beta. D. The stock plots to the left of the market on a security market line graph. E(R) = 3.8% + 1.32(11.4% − 3.8) = 13.83% < 16%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

69.

Why should stock market investors ignore specific risks when calculating required rates of return? A. There is no method for quantifying specific risks. B. Specific can be diversified away. C. Specific risks are compensated by the risk-free rate. D. Beta includes a component to compensate for specific risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Diversification concepts and measures

70.

If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio beta is: A. 0.70. B. 1.05. C. 1.40. D. 2.10. βPortfolio = 0.5 × 1.4 + 0.5 × 0.7 = 1.05

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

71.

A portfolio consists of an index mutual fund which represents the overall market and Treasury bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is 7.6%. What is your best estimate of the portfolio expected rate of return? A. 8.39% B. 7.76% C. 10.80% D. 9.02% E(R)Portfolio = (1 − 0.6)(3.2%) + (0.6)[3.2% + 1(7.6%)] = 7.76%

72.

What is the beta of a security with an expected return of 12% if Treasury bills yield 6% and the market risk premium is 8%? A. 0.50 B. 0.75 C. 0.90 D. 1.50 E(R) = 12% = 6% + β(8%); β = 0.75

73.

The slope of the security market line equals: A. one. B. beta. C. the market risk premium. D. the expected return on the market portfolio. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

74.

A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the market rate of return is 10.6%? A. 2.825% B. 3.250% C. 3.275% D. 3.415% E(R) = 13.53% = rf + 1.4(10.6% − rf); rf = 3.275%

75.

The market portfolio has an expected return of 18% and the risk-free rate is 6%. An investor borrows $100 at the risk-free rate and invests this and a further $100 of his own in the market portfolio. What is his expected return? A. 18.6% B. 19.6% C. 21.6% D. 30.0% βPortfolio = (2 × βmarket) + (−1 × βloan) = (2 × 1) + 0 = 2 Expected return = 6% + 2(18% − 6) = 30%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

76.

If Stock A has a higher expected return than Stock B, which of the following statements is most likely? A. Stock A has more specific risk. B. Stock B plots below the security market line. C. Stock B is a cyclical stock. D. Stock A has a higher beta. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

77.

A stock's risk premium is equal to the: A. expected market return times beta. B. Treasury bill yield plus the expected market return. C. risk-free rate plus the expected market risk premium. D. expected market risk premium times beta. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

78.

Investing borrowed funds in a stock portfolio will generally: A. increase the beta of the portfolio. B. decrease the volatility of the portfolio. C. decrease the expected return on the portfolio. D. increase the market risk premium. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

79.

A stock is expected to pay a year-end dividend of $8 and then to sell at a price of $109. The risk-free interest rate is 4%, the expected market return is 12% and the stock has a beta of 0.8. What is the stock price today? A. $102.99. B. $98.73. C. $105.98. D. $109.00. r = 4% + 0.8(12% − 4%) = 10.4%. P = ($8 + $109) / 1.104 = $105.98.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

80.

Which one of these statements is correct? A. Betas can be measured exactly. B. If a stock has a very low beta, it is likely to have a high beta in the future. C. The expected future risk premium is easy to accurately determine. D. CAPM is widely used as a means of estimating expected returns. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

81.

What happens to the expected portfolio return if the portfolio beta increases from 1.0 to 1.5, the risk-free rate decreases from 5 to 4%, and the market risk premium increases from 8 to 9%? A. It increases from 12 to 14.0%. B. It increases from 13 to 17.5%. C. It increases from 12 to 12.5%. D. It increases from 13 to 13.5%. rp = 5% + 1(8) = 13%; rp = 4% + 1.5(9) = 17.5%

82.

What would you recommend to an investor who is considering an investment that plots below the security market line? A. Invest; The expected return is high relative to the risk. B. Don't invest; The risk is high relative to the expected return. C. Invest; All stocks revert to the SML over time. D. Don't invest; All stocks below the SML are low-growth stocks. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

83.

Investment projects that plot above the security market line have: A. a positive NPV. B. a negative NPV. C. a zero NPV. D. an excessively high discount rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

84.

The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if: A. it results in a negative NPV for the proposal. B. the project has a different degree of risk from the company. C. the company has specific risk. D. the company expects to earn more than the risk-free rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

85.

A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable. A. company cost of capital B. risk-free rate C. market risk premium D. project cost of capital AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

86.

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

Topic: Project analysis and evaluation

87.

The project cost of capital is: A. equal to the company cost of capital. B. less than the company cost of capital. C. greater than the company cost of capital because the project has specific risk. D. not necessarily related to the company cost of capital. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

88.

The minimum acceptable expected rate of return on a project is the: A. project cost of capital. B. company cost of capital. C. risk-free rate of return. D. project beta times the market risk premium. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

89.

If changing discount rates from the company cost of capital to the project cost of capital changes NPV from negative to positive, then the project should use the: A. company cost of capital and be accepted. B. company cost of capital and be rejected. C. project cost of capital and be accepted. D. project cost of capital and be rejected. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

90.

Which one of the following statements best explains the fact that cyclical firms tend to have high betas? A. Their earnings are particularly sensitive to the state of the economy. B. Their stocks are overpriced. C. Their earnings are less diversifiable. D. Their profit margins are small. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy

Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

91.

What type of risk is properly reflected in a project's discount rate? A. Market risk B. Specific risk C. Total risk D. Diversifiable risk AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Systematic and unsystematic risk

92.

Last month a stock with a beta of 1.0 lost 20% while the S&P 500 had a 10% gain. Given this, it is most likely that the: A. stock's beta has been calculated incorrectly. B. S&P 500 cannot represent the overall market. C. firm released some negative information about itself. D. the market index had an exceptionally good month. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

93.

The slope of the fitted line that shows the relationship between a stock's return and the market's return is the: A. market's beta. B. stock's beta. C. market risk premium. D. stock's standard deviation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

94.

Which one of the following is most likely correct for a diversified stock portfolio that exhibits a higher standard deviation than the market index? A. The portfolio contains aggressive stocks with a beta greater than 1.0 B. The portfolio plots below the security market line. C. The portfolio's beta is less than 1.0. D. The portfolio contains a significant amount of specific risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Standard deviation and variance

95.

An investor divides her portfolio into three equal parts, with one part in Treasury bills, one part in a market index, and one part in a mutual fund with beta of 1.50. What is the beta of the investor's overall portfolio? A. 0.83 B. 1.00 C. 1.17 D. 1.25 βPortfolio = (0 + 1 + 1.5) / 3 = 0.83

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

96.

If the market portfolio is expected to return 16%, then a portfolio that is expected to return 13%: A. plots above the security market line. B. plots to the right of the market on an SML graph. C. is not diversified. D. has a beta that is less than 1.0. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

97.

The basic tenet of the CAPM is that a stock's expected risk premium should be: A. greater than the expected market return. B. proportionate to the market return. C. proportionate to the stock's beta. D. greater than the risk-free rate of return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

98.

If the company cost of capital is 20% and a proposed project's cost of capital is 15%, then discounting the projects' cash flows at 20% would: A. determine where the project plots in relation to the security market line. B. make the project look more attractive than it should be. C. be correct from a theoretical perspective. D. be incorrect and could cause the project to be erroneously rejected. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

99.

Over the long run value stocks have: A. had low ratios of book value to market value. B. performed exactly as predicted by CAPM. C. provided a higher return than growth stocks. D. consistently underperformed. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Historical performance

100.

If a project could have a bad outcome: A. the discount rate should be increased. B. expected cash flows should be adjusted downward to reflect this possibility. C. the beta should be increased. D. the market risk premium should be revised downward. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 3 Hard Gradable: automatic Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital. Topic: Project analysis and evaluation

101.

A project costs $3 million, and is expected to generate $1 million in cash flows for the next 4. If the opportunity cost of capital is 15%, the project’s return would plot: A. above the security market line. B. below the security market line. C. on the security market line. D. on the security market line, with a beta of 1.0. The project’s IRR = 12.6%. Therefore, the return on the project will plot below the SML.

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Security market line

102.

An investor prefers to invest in companies that have high operating leverage. How can this be accomplished if the investor also requires a portfolio beta of 1.0? A. Invest 50% in cyclical stocks and 50% in firms with high operating leverage B. Invest 50% in a market index fund and 50% in firms with high operating leverage C. Finance part of the portfolio with borrowing D. Invest a portion of the portfolio in U.S. Treasury securities AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

103.

Which one of the following portfolios might be expected to exhibit less specific risk? A. Five random stocks; portfolio beta = 0.8 B. Three random stocks; portfolio beta = 1.2 C. Ten random stocks; portfolio beta = 1.0 D. Twelve random stocks; portfolio beta unknown AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Diversification concepts and measures

104.

If the plot of a portfolio's returns against returns on the market index produces a tight pattern, then the portfolio: A. appears to be well diversified. B. has a beta of 0. C. has very little systematic risk. D. has a risk premium lower than the market. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security. Topic: Beta

105.

If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then the investor should expect to receive: A. the risk-free rate plus 75% of the expected return on the market. B. the risk-free rate plus 75% of the expected market risk premium. C. 75% of the expected return on the market. D. 25% of the risk-free rate plus 75% of the expected market risk premium. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

106.

Which statement is correct? A. the superior performance of value stocks is exactly what the CAPM would predict. B. the CAPM predicts that investors are concerned only with the risk that cannot be diversified away. C. few financial managers in practice use the CAPM to estimate the cost of capital. D. the CAPM is a model of actual returns whereas the cost of capital is concerned with expected returns. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand. Topic: Capital asset pricing model

Chapter 12 Test bank - Static Summary Category AACSB: Analytical Thinking

# of Questions 25

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

106

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

106

Learning Objective: 12-01 Measure and interpret the market risk, or beta, of a security.

Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.

Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital.

Topic: Beta

Topic: Capital asset pricing model

Topic: Cost of capital-general

Topic: Diversification concepts and measures

Topic: Historical performance

Topic: Portfolio return

Topic: Project analysis and evaluation

Topic: Security market line

Topic: Standard deviation and variance

Topic: Stock returns and yields

Topic: Systematic and unsystematic risk

Chapter 13 Test bank - Static Student: ___________________________________________________________________________

Capital structure refers to a firm's mix of long-term debt and equity financing. True

The company cost of capital is the expected rate of return that investors demand from the company's assets and operations. True

False

The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders. True

False

A firm's cost of capital should be computed using the book weights of each financing source. True

False

If a project has a zero NPV when the expected cash flows are discounted at the weighted-average cost of capital, then the project's cash flows are just sufficient to give debtholders and shareholders the return they require. True

False

The weighted-average cost of capital is the expected rate of return on a portfolio of all the firm's securities, adjusted for the tax savings on interest payments. True

False

The company cost of capital is the minimum acceptable rate of return for any project the firm undertakes. True

False

If the firm decreases its debt ratio, both the debt and the equity will become riskier. The debtholders and equityholders will require a higher return to compensate for the increased risk. True

False

10. A firm's weighted-average cost of capital will generally increase if the firm lowers its debt-equity ratio. True

False

11. Preferred stock should be ignored when computing a firm's weighted-average cost of capital. True

False

12. Both the capital asset pricing model and the dividend discount model can be used to determine the cost of equity financing. True

False

13. The cost of equity will generally increase for risky firms when the risk-free rate of return increases. True

False

14. Interest tax shields are available to the firm on debt and preferred stock but not on common equity. True

False

15. New projects should be undertaken by firms only if they have the same risk as existing assets. True

False

16. Projects that have a zero NPV when the cash flows are discounted at the WACC will provide just sufficient returns to creditors and shareholders. True

False

17. As a firm increases its debt ratio, debtholders are likely to demand higher rates of return. True

False

18. An increase in a firm's debt ratio will have no effect on the required rate of return for equity holders. True

False

19. A firm's cost of capital should be used as the discount rate for every new project the firm considers. True

False

20. The mix of a company's short-term financing is referred to as its capital structure. True

False

21. To a company, the cost of interest payments on its bonds is reduced by the amount of tax savings generated by that interest. True

False

22. The interest tax shield generated by a project's actual equity financing is accounted for by using the after-tax cost of equity in the WACC. True

False

23. Assuming a project has the same risk and financing as the firm, it will have a positive NPV if its rate of return is greater than the firm's WACC. True

False

24. For healthy firms, the expected return on their bonds is close to their yield to maturity. True

False

25. One way to estimate the expected return on bonds is to find the yield to maturity on recently-issued bonds with similar characteristics and risks. True

False

26. The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders. True

False

27. When using the WACC as a discount rate, it is often adjusted upward for riskier projects and downward for safer projects. True

False

28. A change in the company's capital structure will change the amount of taxes paid but will not change the WACC. True

False

29. Capital structure decisions refer to the: A. dividend yield of the firm's stock. B. blend of equity and debt used by the firm. C. capital gains available on the firm's stock. D. maturity date for the firm's securities. 30. What is the debt ratio of a firm that has outstanding $15 million in bonds and equity with a market value of $35 million? A. 15% B. 30% C. 35% D. 43% 31. To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's: A. weighted-average cost of capital. B. pre-tax cost of debt. C. after-tax cost of debt. D. cost of equity. 32. The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity, and a 35% tax rate is: A. 8.63%. B. 9.12%. C. 10.45%. D. 13.80%.

33. The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 8% cost of debt, 15% cost of equity, and a 34% tax rate is: A. 12.20%. B. 8.63%. C. 11.11%. D. 13.80%. 34. Why is debt financing said to include a tax shield for the company? A. Taxes are reduced by the amount of the debt. B. Taxes are reduced by the amount of the interest. C. Taxable income is reduced by the amount of the debt. D. Taxable income is reduced by the amount of the interest. 35. If the after-tax cost of debt is 10%, what is the pretax cost for a firm in the 35% tax bracket? A. 5.85% B. 12.15% C. 15.38% D. 25.71% 36. What is a firm's weighted-average cost of capital for a firm that is financed 45% by debt? The debt has a 10% required return and the equity has a 17% required return. The tax rate is 35%. A. 13.85% B. 12.28% C. 13.50% D. 9.00% 37. What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 40% tax rate? A. 9.6% B. 12.0% C. 13.6% D. 16.0% 38. Company X has 2 million shares of common stock outstanding with a book value of $2 per share. The stock trades for $3 per share. It also has $2 million in face value of debt that trades at 90% of face value. What is the debt ratio that should be used to calculate WACC? A. 13.91% B. 23.08% C. 31.03% D. 27.67%

39. If the tax rate is 35%, what is the cost of preferred stock that sells for $10 per share and pays a $1.20 dividend? A. 4.20% B. 7.80% C. 8.33% D. 12.00% 40. A firm is financed 55% by common stock, 10% by preferred stock and 35% by debt. The required return is 15% on the common, 10% on the preferred, and 8% on the debt. If the tax rate is 35% what is the WACC? A. 10.72% B. 11.07% C. 11.70% D. 12.05% 41. A project requires an investment of $10 million and offers an annual after-tax cash flow of $1,250,000 indefinitely. If the firm's WACC is 12.5% and the project is riskier than the firm’s average projects, should it be accepted%? A. Yes, since the project's NPV is positive. B. Yes, since a zero NPV indicates marginal acceptability. C. No, since the project's NPV is zero. D. No, since the project's NPV is negative. 42. How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 40%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return? A. $1,392,000 B. $1,488,000 C. $2,480,000 D. $2,800,000 43. How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 35%, there is $13 million in common stock requiring a 10% return, and $6 million in bonds requiring a 6% return? A. $1,392,000 B. $1,488,000 C. $2,360,000 D. $2,480,000 44. Which one of the following statements is incorrect? A. The equity component of WACC reflects the return expected by the company’s shareholders. B. Market values should be used in calculating WACC. C. Preferred equity is a separate component of WACC. D. There is a tax shield on the equity dividends paid.

45. What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued? A. The debt-to-value ratio will be overstated. B. The debt-to-value ratio will be understated. C. There will be no effect on WACC decisions. D. It cannot be determined without knowing interest rates. 46. A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39. There are 5,000 shares of preferred stock with a book value of $22 and a market value of $26. There is a $400,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC? A. 7.25% B. 13.74% C. 11.48% D. 15.09% 47. What would you estimate as the cost of equity if a stock sells for $40, pays a $4.25 dividend, and is expected to grow at a constant rate of 5%? A. 17.46% B. 14.52% C. 12.69% D. 15.63% 48. What is the expected growth rate in dividends for a firm in which shareholders require an 18% rate of return and the dividend yield is 10%? A. 1.8% B. 5.2% C. 8.0% D. 28.0% 49. What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per share and a book value of $50 per share? A. $2.92 B. $4.50 C. $4.68 D. $4.86 50. If a firm earns the WACC on its assets, then: A. equityholders will be satisfied, but bondholders will not. B. bondholders will be satisfied, but equityholders will not. C. all investors will earn their minimum required rate of return. D. the firm is investing in only positive NPV projects.

51. As debt is added to the capital structure, the: A. WACC will continually decline. B. WACC will continually increase. C. cost of debt can be expected to rise. D. WACC will be unaffected. 52. An implicit cost of increasing the proportion of debt in a firm's capital structure is that: A. the firm's asset beta will increase. B. shareholders will demand a higher rate of return. C. the tax shield will not apply to the added debt. D. the cost of equity will decrease. 53. A firm is considering a project that will generate perpetual cash flows of $50,000 per year beginning next year. The project has the same risk as the firm's overall operations. If the firm's WACC is 12%, and its debt-to-equity ratio is 1.33, what is the most it could pay for the project and still earn its required rate of return? A. $313,283 B. $375,094 C. $416,667 D. $554,167 54. A firm's WACC: A. is the proper discount rate for every project the firm undertakes. B. is used to value all of the firm's existing projects. C. is a benchmark discount rate that may be adjusted for the riskiness of each project. D. is for informational value only and should never be used as a discount rate. 55. Other things equal, which of the following will decrease the WACC of a firm that has both debt and equity in its capital structure? A. An increase in the stock’s beta B. An increase in the expected market return C. An increase in the tax rate D. An increase in the yield on preferred stock 56. Calculate a firm's WACC given that the total value of the firm is $2 million, $600,000 of which is debt, the pre-tax cost of debt is 10%, and the cost of equity is 15%. The firm pays no taxes. A. 9.0% B. 11.5% C. 13.5% D. 14.4%

57. A firm has a debt-to-equity ratio of 1/4. The WACC is 18.6%, and the pretax cost of debt is 9.4%. What is the cost of common equity if the tax rate is 34%? A. 19.90% B. 20.90% C. 21.70% D. 22.73% 58. For a company that pays no corporate taxes, its WACC will be equal to: A. the expected return on its assets. B. the expected return on its debt. C. the total value of its assets. D. the expected return on its equity. 59. A firm is 40% financed by debt with a yield-to-maturity of 8.5%. The equity has a beta of 1.3, the market risk premium is 8.4% and the risk-free rate is 3.8%. What is the firm's WACC if the tax rate is 34%? A. 10.74% B. 11.08% C. 11.61% D. 11.38% 60. If a firm has twice as much equity as debt in its capital structure, then the firm is financed with: A. 75.0% debt. B. 66.7% equity. C. 40.0% debt. D. 33.3% equity. 61. If a firm has three times as much equity as debt in its capital structure, then the firm is financed with: A. 25.0% debt. B. 90.0% equity. C. 40.0% debt. D. 33.3% debt. 62. If a company's WACC is less than the required return on equity, then the firm: A. is financed with more than 50% debt. B. is perceived to be safe. C. has debt in its capital structure. D. is all equity financed. 63. The company cost of capital is the return that is expected on a portfolio of the company's: A. existing securities. B. equity securities. C. debt securities. D. proposed securities.

64. A firm has just paid its annual dividend of $5.64 a share. Thereafter the dividend is expected to increase at a rate of 2% a year. If the firm's stock currently sells for $60 a share, what is the cost of equity? A. 11.59% B. 14.33% C. 11.40% D. 9.40% 65. What is the WACC for a firm financed with 30% debt if the debt investors require a return of 12.5% and equity investors require a 16% return? The corporate tax rate is 20%. A. 11.8% B. 13.3% C. 14.2% D. 14.8% 66. Which one of the following changes would tend to increase the WACC for a tax-paying firm? A. Decrease the proportion of equity financing B. Increase the market value of the debt C. Decrease the proportion of debt financing D. Decrease the market value of the equity 67. A firm is considering expanding its current operations and has estimated the internal rate of return on that expansion to be 12.2%. The firm's WACC is 11.8%. Given this, you know that the: A. project will have a lower debt-equity ratio than the firm's current operations. B. appropriate discount rate for the project is between 11.8% and 12.2%. C. project has slightly more risk than the firm's current operations. D. expansion should be undertaken as it has a positive net present value. 68. A firm has 12,500 shares of stock outstanding that sell for $42 each. The book value of equity is $400,000. The firm has also issued $250,000 face value of debt that is currently quoted at 101.2. What value should be used as the weight of equity when computing WACC? A. 67.48% B. 72.09% C. 61.54% D. 69.74% 69. A tax-paying firm is currently financed with 50% debt and 50% equity. The after-tax cost of debt is 6% and the cost of equity is 12%. If the firm issues some 8% preferred stock at par, then the firm's WACC will: A. increase. B. decrease. C. either increase or decrease depending upon the amount of stock issued. D. not be affected.

70. Assume a firm's debt is selling at face value. What is the firm's cost of debt if the debt has a coupon rate of 7.5% and the tax rate is 35%? A. 4.88% B. 4.97% C. 5.21% D. 5.35% 71. What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7%, the tax rate is 35%, and the required return on equity is 18%? A. 54.00% B. 63.64% C. 70.26% D. 77.78% 72. What proportion of a firm is equity financed if the WACC is 14%, the before-tax cost of debt is 10.77%, the tax rate is 35%, and the required return on equity is 18%? A. 54.00% B. 63.64% C. 70.26% D. 77.78% 73. A firm has a debt-to-value ratio of 40%, a cost of equity of 14%, and an after-tax cost of debt of 5.5%. It plans to launch a new product that will produce cash flows of $398,000 next year and $211,000 in year 2. If this project is about as risky as the firm’s existing assets, what is the present value of the project? A. $458,008 B. $481,707 C. $500,614 D. $532,349 74. Al's Market plans to close after 3 more years. The firm expects to have free cash flows of $148,000 next year, $128,000 in Year 2, and $65,000 in Year 3 after incurring the costs of closing. The firm's cost of equity is 15.5% and its after-tax cost of debt is 6.2%. What is the present value of the firm if its debt to value ratio is 30%? A. $312,020 B. $248,915 C. $277,467 D. $301,004 75. A proposed project has a positive NPV if it is financed entirely by equity. If the project can sensibly be financed partly by debt and the firm pays tax, will the project remain acceptable? A. Yes, using debt will increase the NPV. B. No, using debt will decrease the NPV. C. The project may now become unacceptable. D. There will be no change in the project's NPV.

76. What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the firm's tax rate is 35%? A. 7.8% B. 8.5% C. 12.0% D. 16.2% 77. What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their respective costs are 6% after tax, 12%, and 18%? The firm's tax rate is 35%. A. 9.48% B. 11.16% C. 12.00% D. 15.60% 78. What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their respective costs are 9.23% before tax, 12%, and 18%? The firm's tax rate is 35%. A. 9.48% B. 11.16% C. 12.00% D. 15.60% 79. A project will generate a $1 million net cash flow annually in perpetuity. If the project costs $7 million, what is the break-even WACC? A. 13.33% B. 12.08% C. 14.29% D. 16.67% 80. Which one of the following changes offers the greatest chance of changing a project's NPV from negative to positive? A. Substituting preferred stock for debt B. Selling the debt at less than par value C. Reducing the risk of the project D. Reducing the maturity of the debt 81. What decision should be made on a project with above-average market risk? A. Accept if the cash flows discounted at the WACC have a positive NPV. B. Discount the cash flows at the IRR and accept if NPV is positive. C. Accept if the IRR is greater than the WACC. D. Use a higher discount rate than the WACC to reflect the project’s risk and accept if NPV is positive at this higher discount rate.

82. If equity investors require a 20% rate of return, what is the maximum acceptable amount of equity financing for a project with cash flows of $2 million a year in perpetuity before tax and interest? The project supports debt of $3 million with a 10% coupon, and the tax rate is 35%. A. $5.53 million B. $5.87 million C. $8.5 million D. $9.03 million 83. For purposes of computing the WACC, if the book value of equity exceeds the market value of equity, then: A. the book value of equity should be used. B. the book value of equity less retained earnings should be used. C. the market value of equity should be used. D. the market value of equity less retained earnings should be used. 84. How much cash flow before tax and interest is necessary to support a project if $2 million is used to pay interest, the tax rate is 35%, and equity investors require annual income of $4 million? A. $7.40 million B. $8.10 million C. $8.15 million D. $8.85 million 85. What equity proportion should be used when calculating WACC for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity? A. 50.00% B. 54.18% C. 56.55% D. 60.47% 86. According to CAPM estimates, what is the cost of equity for a firm with a beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%? A. 19.5% B. 21.0% C. 22.5% D. 24.0% 87. What return on equity do investors expect for a firm with a $55 share price, an expected dividend of $4.60, a beta of 0.9, and a constant growth rate of 3.5%? A. 9.87% B. 12.48% C. 13.95% D. 11.86%

88. Changing the capital structure by adding debt will: A. reduce the return that shareholders require. B. reduce default risk. C. increase debtholder risk. D. reduce the cost of debt. 89. The company cost of capital: A. measures the return that investors require from the company. B. depends on current profits and cash flows. C. is measured using security book values. D. depends on historical profits and cash flows. 90. XYZ Company issues common stock at a price of $25 a share. The firm expects to pay a dividend of $2.20 a share next year. If the dividend is expected to grow at 2.5% annually, what is XYZ's cost of common equity? A. 6.3% B. 11.3% C. 13.7% D. 8.9% 91. Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5% and the return on the market is 13.6%. A. 11.54% B. 13.08% C. 16.18% D. 18.02% 92. Plasti-tech Inc. is financed 60% with equity and 40% with debt. Currently, its debt has a pretax interest rate of 12%. Plasti-tech's common stock trades at $15.00 per share and its most recent dividend was $1.00. Future dividends are expected grow by 4%. If the tax rate is 34%, what is Plasti-tech's WACC? A. 7.39% B. 9.57% C. 9.73% D. 11.20% 93. The capital structure for the CR Corporation includes bonds valued at $5,500 and common stock valued at $11,000. If CR has an after-tax cost of debt of 6%, and a cost of common stock of 16%, what is its WACC? A. 9.33% B. 12.67% C. 13.33% D. 14.67%

94. What is the yield to maturity on Dotte Inc.'s bonds if its after-tax cost of debt is 10% and its tax rate is 35%? A. 6.50% B. 13.50% C. 15.38% D. 16.42% 95. Increasing debt financing will do all of the following except: A. cause investors to demand a higher interest rate on debt. B. increase the risk to the firm's common stockholders. C. cause stockholders to demand a higher return. D. decrease the firm's cost of common equity. 96. Suppose an analyst estimates that free cash flow will be $2.43 million in year 5. What is the present value of this free cash flow if the company cost of capital is 12%, the WACC is 10%, and the equity cost of capital is 15%? A. $2,113,043 B. $1,208,139 C. $1,508,839 D. $1,378,847 97. WACC can be used to determine the value of a firm by discounting the firm's: A. after-tax net profits. B. pretax profits. C. cash inflows. D. free cash flows.

Chapter 13 Test bank - Static Key 1.

Capital structure refers to a firm's mix of long-term debt and equity financing. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

The company cost of capital is the expected rate of return that investors demand from the company's assets and operations. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Cost of capital-general

The company cost of capital is the minimum acceptable rate of return for any project the firm undertakes. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Divisional and project costs of capital

The weighted-average cost of capital is the expected rate of return on a portfolio of all the firm's securities, adjusted for the tax savings on interest payments. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

A firm's cost of capital should be computed using the book weights of each financing source. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because higher levels of debt increase the required rate of return to equity. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

If the firm decreases its debt ratio, both the debt and the equity will become riskier. The debtholders and equityholders will require a higher return to compensate for the increased risk. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Cost of capital-general

10.

A firm's weighted-average cost of capital will generally increase if the firm lowers its debt-equity ratio. TRUE AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

11.

Preferred stock should be ignored when computing a firm's weighted-average cost of capital. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

12.

Both the capital asset pricing model and the dividend discount model can be used to determine the cost of equity financing. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

13.

The cost of equity will generally increase for risky firms when the risk-free rate of return increases. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

14.

Interest tax shields are available to the firm on debt and preferred stock but not on common equity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of preferred stock

15.

New projects should be undertaken by firms only if they have the same risk as existing assets. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Divisional and project costs of capital

16.

Projects that have a zero NPV when the cash flows are discounted at the WACC will provide just sufficient returns to creditors and shareholders. TRUE AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

17.

As a firm increases its debt ratio, debtholders are likely to demand higher rates of return. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

18.

An increase in a firm's debt ratio will have no effect on the required rate of return for equity holders. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

19.

A firm's cost of capital should be used as the discount rate for every new project the firm considers. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Divisional and project costs of capital

20.

The mix of a company's short-term financing is referred to as its capital structure. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic

Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

21.

To a company, the cost of interest payments on its bonds is reduced by the amount of tax savings generated by that interest. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

22.

The interest tax shield generated by a project's actual equity financing is accounted for by using the after-tax cost of equity in the WACC. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

23.

Assuming a project has the same risk and financing as the firm, it will have a positive NPV if its rate of return is greater than the firm's WACC. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

24.

For healthy firms, the expected return on their bonds is close to their yield to maturity. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

25.

One way to estimate the expected return on bonds is to find the yield to maturity on recently-issued bonds with similar characteristics and risks. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium

Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

26.

The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide an acceptable return to its security holders. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

27.

When using the WACC as a discount rate, it is often adjusted upward for riskier projects and downward for safer projects. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Divisional and project costs of capital

28.

A change in the company's capital structure will change the amount of taxes paid but will not change the WACC. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

29.

Capital structure decisions refer to the: A. dividend yield of the firm's stock. B. blend of equity and debt used by the firm. C. capital gains available on the firm's stock. D. maturity date for the firm's securities. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

30.

What is the debt ratio of a firm that has outstanding $15 million in bonds and equity with a market value of $35 million? A. 15% B. 30% C. 35% D. 43% Debt ratio = $15m / ($15m + 35m) = 0.30, or 30%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

31.

To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's: A. weighted-average cost of capital. B. pre-tax cost of debt. C. after-tax cost of debt. D. cost of equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Topic: Firm valuation

32.

The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity, and a 35% tax rate is: A. 8.63%. B. 9.12%. C. 10.45%. D. 13.80%. WACC = [0.65 × 0.08 × (1 − 0.35)] + (0.35 × 0.15) = 0.0863, or 8.63%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

33.

The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 8% cost of debt, 15% cost of equity, and a 34% tax rate is: A. 12.20%. B. 8.63%. C. 11.11%. D. 13.80%. WACC = [0.40 × 0.08 × (1 − 0.34)] + (0.60 × 0.15) = 0.1111, or 11.11%

34.

Why is debt financing said to include a tax shield for the company? A. Taxes are reduced by the amount of the debt. B. Taxes are reduced by the amount of the interest. C. Taxable income is reduced by the amount of the debt. D. Taxable income is reduced by the amount of the interest. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

35.

If the after-tax cost of debt is 10%, what is the pretax cost for a firm in the 35% tax bracket? A. 5.85% B. 12.15% C. 15.38% D. 25.71% After-tax cost of debt = 0.10 / (1 − 0.35) = 0.1538, or 15.38%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

36.

What is a firm's weighted-average cost of capital for a firm that is financed 45% by debt? The debt has a 10% required return and the equity has a 17% required return. The tax rate is 35%. A. 13.85% B. 12.28% C. 13.50% D. 9.00% WACC = 0.45 × [10% × (1 − 0.35)] + 0.55 × 17% = 12.28%

37.

What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 40% tax rate? A. 9.6% B. 12.0% C. 13.6% D. 16.0% WACC = [0.5 × 0.12 × (1 − 0.40)] + (0.5 × 0.20) = 0.136, or 13.6%

38.

Company X has 2 million shares of common stock outstanding with a book value of $2 per share. The stock trades for $3 per share. It also has $2 million in face value of debt that trades at 90% of face value. What is the debt ratio that should be used to calculate WACC? A. 13.91% B. 23.08% C. 31.03% D. 27.67% Debt ratio = (0.90 × $2m) / [(2m × $3) + (0.90 × $2m)] = 0.2308, or 23.08%

39.

If the tax rate is 35%, what is the cost of preferred stock that sells for $10 per share and pays a $1.20 dividend? A. 4.20% B. 7.80% C. 8.33% D. 12.00% Cost of preferred = $1.20 / $10.00 = 0.12, or 12%

40.

A firm is financed 55% by common stock, 10% by preferred stock and 35% by debt. The required return is 15% on the common, 10% on the preferred, and 8% on the debt. If the tax rate is 35% what is the WACC? A. 10.72% B. 11.07% C. 11.70% D. 12.05% WACC = (0.55 × 0.15) + (0.1 × 0.1) + [0.35 × 0.08 × (1 − 0.35)] = 0.1107, or 11.07%

41.

A project requires an investment of $10 million and offers an annual after-tax cash flow of $1,250,000 indefinitely. If the firm's WACC is 12.5% and the project is riskier than the firm’s average projects, should it be accepted%? A. Yes, since the project's NPV is positive. B. Yes, since a zero NPV indicates marginal acceptability. C. No, since the project's NPV is zero. D. No, since the project's NPV is negative. NPV at WACC = −$10m + $1.25m / 0.125 = $0; However, the 12.5% rate does not reflect the projects' greater risk; thus the project's NPV is negative.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Divisional and project costs of capital

42.

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 40%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return? A. $1,392,000 B. $1,488,000 C. $2,480,000 D. $2,800,000 AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of capital-general

43.

How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 35%, there is $13 million in common stock requiring a 10% return, and $6 million in bonds requiring a 6% return? A. $1,392,000 B. $1,488,000 C. $2,360,000 D. $2,480,000 AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cash flows

44.

Which one of the following statements is incorrect? A. The equity component of WACC reflects the return expected by the company’s shareholders. B. Market values should be used in calculating WACC. C. Preferred equity is a separate component of WACC. D. There is a tax shield on the equity dividends paid. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

45.

What will be the effect of using the book value of debt in WACC decisions if interest rates have decreased substantially since a firm's long-term bonds were issued? A. The debt-to-value ratio will be overstated. B. The debt-to-value ratio will be understated. C. There will be no effect on WACC decisions. D. It cannot be determined without knowing interest rates. Assume for example that the market value of equity is $5 million, the book value of debt is $2 million, and the value of the firm is $7 million. In the example, the debt-to-value ratio is 0.286. However, if the market value of debt is $2.5 million due to decreased interest rates, the value of the firm is $7.5 million and the debt-to-value ratio is 0.333. The key is that the numerator of the ratio changes proportionately more than the denominator.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Capital structure weights

46.

A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39. There are 5,000 shares of preferred stock with a book value of $22 and a market value of $26. There is a $400,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC? A. 7.25% B. 13.74% C. 11.48% D. 15.09% Weight of preferred = (5,000 × $26) / [(12,000 × $39) + (5,000 × $26) + ($400,000 × 0.87)] = 0.1374, or 13.74%

47.

What would you estimate as the cost of equity if a stock sells for $40, pays a $4.25 dividend, and is expected to grow at a constant rate of 5%? A. 17.46% B. 14.52% C. 12.69% D. 15.63% E(R) = $4.25 / $40 + 0.05 = 0.1563, or 15.63%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze

Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

48.

What is the expected growth rate in dividends for a firm in which shareholders require an 18% rate of return and the dividend yield is 10%? A. 1.8% B. 5.2% C. 8.0% D. 28.0% g = 18% − 10 = 8%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

49.

What dividend is paid on preferred stock if investors require a 9% rate of return and the stock has a market value of $54 per share and a book value of $50 per share? A. $2.92 B. $4.50 C. $4.68 D. $4.86 0.09 = dividend / $54; Dividend = $4.86

50.

If a firm earns the WACC on its assets, then: A. equityholders will be satisfied, but bondholders will not. B. bondholders will be satisfied, but equityholders will not. C. all investors will earn their minimum required rate of return. D. the firm is investing in only positive NPV projects. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

51.

As debt is added to the capital structure, the: A. WACC will continually decline. B. WACC will continually increase. C. cost of debt can be expected to rise. D. WACC will be unaffected. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

52.

An implicit cost of increasing the proportion of debt in a firm's capital structure is that: A. the firm's asset beta will increase. B. shareholders will demand a higher rate of return. C. the tax shield will not apply to the added debt. D. the cost of equity will decrease. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

53.

A firm is considering a project that will generate perpetual cash flows of $50,000 per year beginning next year. The project has the same risk as the firm's overall operations. If the firm's WACC is 12%, and its debt-to-equity ratio is 1.33, what is the most it could pay for the project and still earn its required rate of return? A. $313,283 B. $375,094 C. $416,667 D. $554,167 PV = $50,000 / 0.12 = $416,667

54.

A firm's WACC: A. is the proper discount rate for every project the firm undertakes. B. is used to value all of the firm's existing projects. C. is a benchmark discount rate that may be adjusted for the riskiness of each project. D. is for informational value only and should never be used as a discount rate. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

55.

Other things equal, which of the following will decrease the WACC of a firm that has both debt and equity in its capital structure? A. An increase in the stock’s beta B. An increase in the expected market return C. An increase in the tax rate D. An increase in the yield on preferred stock AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

56.

Calculate a firm's WACC given that the total value of the firm is $2 million, $600,000 of which is debt, the pre-tax cost of debt is 10%, and the cost of equity is 15%. The firm pays no taxes. A. 9.0% B. 11.5% C. 13.5% D. 14.4% WACC = 0.10($600,000 / $2m) + 0.15[($2m − 600,000) / $2m] = 0.135, or 13.5%

57.

A firm has a debt-to-equity ratio of 1/4. The WACC is 18.6%, and the pretax cost of debt is 9.4%. What is the cost of common equity if the tax rate is 34%? A. 19.90% B. 20.90% C. 21.70% D. 22.73% D/V = 0.2 and E/V = 0.8; 18.6 = 0.2(9.4)(1 − 0.34) + 0.8(re); re = 21.70%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital.

Topic: Weighted-average cost of capital

58.

For a company that pays no corporate taxes, its WACC will be equal to: A. the expected return on its assets. B. the expected return on its debt. C. the total value of its assets. D. the expected return on its equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

59.

A firm is 40% financed by debt with a yield-to-maturity of 8.5%. The equity has a beta of 1.3, the market risk premium is 8.4% and the risk-free rate is 3.8%. What is the firm's WACC if the tax rate is 34%? A. 10.74% B. 11.08% C. 11.61% D. 11.38% re = 3.8% + 1.3(8.4%) = 14.72% WACC = (1 − 0.40)(0.1472) + 0.40(.085)(1 − 0.34) = 0.1108, or 11.08%

60.

If a firm has twice as much equity as debt in its capital structure, then the firm is financed with: A. 75.0% debt. B. 66.7% equity. C. 40.0% debt. D. 33.3% equity. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

61.

If a firm has three times as much equity as debt in its capital structure, then the firm is financed with: A. 25.0% debt. B. 90.0% equity. C. 40.0% debt. D. 33.3% debt. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

62.

If a company's WACC is less than the required return on equity, then the firm: A. is financed with more than 50% debt. B. is perceived to be safe. C. has debt in its capital structure. D. is all equity financed. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

63.

The company cost of capital is the return that is expected on a portfolio of the company's: A. existing securities. B. equity securities. C. debt securities. D. proposed securities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

64.

A firm has just paid its annual dividend of $5.64 a share. Thereafter the dividend is expected to increase at a rate of 2% a year. If the firm's stock currently sells for $60 a share, what is the cost of equity? A. 11.59% B. 14.33% C. 11.40% D. 9.40% re = ($5.64 × 1.02) / $60 + 0.02 = 0.11588, or 11.59%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

65.

What is the WACC for a firm financed with 30% debt if the debt investors require a return of 12.5% and equity investors require a 16% return? The corporate tax rate is 20%. A. 11.8% B. 13.3% C. 14.2% D. 14.8% WACC = 0.3(0.8 × 12.5) + (1 − 0.3)(16) = 0.142, or 14.2%

66.

Which one of the following changes would tend to increase the WACC for a tax-paying firm? A. Decrease the proportion of equity financing B. Increase the market value of the debt C. Decrease the proportion of debt financing D. Decrease the market value of the equity AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

67.

A firm is considering expanding its current operations and has estimated the internal rate of return on that expansion to be 12.2%. The firm's WACC is 11.8%. Given this, you know that the: A. project will have a lower debt-equity ratio than the firm's current operations. B. appropriate discount rate for the project is between 11.8% and 12.2%. C. project has slightly more risk than the firm's current operations. D. expansion should be undertaken as it has a positive net present value. Since the project is an expansion project, the risk-level of the project is equal to the risk-level of the current firm. Thus, the project NPV will be positive since the IRR exceeds the required return.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

68.

A firm has 12,500 shares of stock outstanding that sell for $42 each. The book value of equity is $400,000. The firm has also issued $250,000 face value of debt that is currently quoted at 101.2. What value should be used as the weight of equity when computing WACC? A. 67.48% B. 72.09% C. 61.54% D. 69.74% We = (12,500 × $42) / [(12,500 × $42) + 1.012($250,000)] = 0.6748, or 67.48%

69.

A tax-paying firm is currently financed with 50% debt and 50% equity. The after-tax cost of debt is 6% and the cost of equity is 12%. If the firm issues some 8% preferred stock at par, then the firm's WACC will: A. increase. B. decrease. C. either increase or decrease depending upon the amount of stock issued. D. not be affected. Current WACC = 0.50(0.06) + 0.50(0.12) = 0.09, or 9%; Including some preferred stock at a cost of 8%, will lower the firm's WACC.

70.

Assume a firm's debt is selling at face value. What is the firm's cost of debt if the debt has a coupon rate of 7.5% and the tax rate is 35%? A. 4.88% B. 4.97% C. 5.21% D. 5.35% Rd = 7.5%(1 − 0.35) = 4.88%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic

Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of debt

71.

What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7%, the tax rate is 35%, and the required return on equity is 18%? A. 54.00% B. 63.64% C. 70.26% D. 77.78% 14% = (1 − x)(7%) + (x)18%; x = 63.64%

72.

What proportion of a firm is equity financed if the WACC is 14%, the before-tax cost of debt is 10.77%, the tax rate is 35%, and the required return on equity is 18%? A. 54.00% B. 63.64% C. 70.26% D. 77.78% 0.14 = (1 − x)(10.77%)(1 − 0.35) + x(18%); x = 63.64%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

73.

A firm has a debt-to-value ratio of 40%, a cost of equity of 14%, and an after-tax cost of debt of 5.5%. It plans to launch a new product that will produce cash flows of $398,000 next year and $211,000 in year 2. If this project is about as risky as the firm’s existing assets, what is the present value of the project? A. $458,008 B. $481,707 C. $500,614 D. $532,349 WACC = 0.4(5.5%) + (1 − 0.4)(14%) = 10.6% PV = $398,000 / 1.106 + $211,000 / 1.106 2 = $532,349

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Topic: Firm valuation

74.

Al's Market plans to close after 3 more years. The firm expects to have free cash flows of $148,000 next year, $128,000 in Year 2, and $65,000 in Year 3 after incurring the costs of closing. The firm's cost of equity is 15.5% and its after-tax cost of debt is 6.2%. What is the present value of the firm if its debt to value ratio is 30%? A. $312,020 B. $248,915 C. $277,467 D. $301,004 WACC = 0.3(6.2%) + (1 − 0.3)(15.5%) = 12.71% PV = $148,000 / 1.1271 + $128,000 / 1.12712 + $65,000 / 1.12713 = $277,467

75.

A proposed project has a positive NPV if it is financed entirely by equity. If the project can sensibly be financed partly by debt and the firm pays tax, will the project remain acceptable? A. Yes, using debt will increase the NPV. B. No, using debt will decrease the NPV. C. The project may now become unacceptable. D. There will be no change in the project's NPV. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

76.

What is the after-tax cost of preferred stock that pays a 12% dividend and sells at par if the firm's tax rate is 35%? A. 7.8% B. 8.5% C. 12.0% D. 16.2% There is no adjustment for taxes on preferred stock. Therefore, after-tax cost = pretax cost.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of preferred stock

77.

What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their respective costs are 6% after tax, 12%, and 18%? The firm's tax rate is 35%. A. 9.48% B. 11.16% C. 12.00% D. 15.60% WACC = (0.4 × 6%) + (0.2 × 12%) + (0.4 × 18%) = 12.00%

78.

What is the WACC for a firm with 40% debt, 20% preferred stock, and 40% equity if their respective costs are 9.23% before tax, 12%, and 18%? The firm's tax rate is 35%. A. 9.48% B. 11.16% C. 12.00% D. 15.60% WACC = [0.4 × ((1 − 0.35) × 9.23%)] + (0.2 × 12%) + (0.4 × 18%) = 12.0%

79.

A project will generate a $1 million net cash flow annually in perpetuity. If the project costs $7 million, what is the breakeven WACC? A. 13.33% B. 12.08% C. 14.29% D. 16.67% $7m = $1m / WACC; WACC = 14.29%

80.

Which one of the following changes offers the greatest chance of changing a project's NPV from negative to positive? A. Substituting preferred stock for debt B. Selling the debt at less than par value C. Reducing the risk of the project D. Reducing the maturity of the debt AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

81.

What decision should be made on a project with above-average market risk? A. Accept if the cash flows discounted at the WACC have a positive NPV. B. Discount the cash flows at the IRR and accept if NPV is positive. C. Accept if the IRR is greater than the WACC. D. Use a higher discount rate than the WACC to reflect the project’s risk and accept if NPV is positive at this higher discount rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

82.

If equity investors require a 20% rate of return, what is the maximum acceptable amount of equity financing for a project with cash flows of $2 million a year in perpetuity before tax and interest? The project supports debt of $3 million with a 10% coupon, and the tax rate is 35%. A. $5.53 million B. $5.87 million C. $8.5 million D. $9.03 million Maximum equity = $1,105,000 / 0.20 = $5,525,000, or $5.53 million

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

83.

For purposes of computing the WACC, if the book value of equity exceeds the market value of equity, then: A. the book value of equity should be used. B. the book value of equity less retained earnings should be used. C. the market value of equity should be used. D. the market value of equity less retained earnings should be used. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Capital structure weights

84.

How much cash flow before tax and interest is necessary to support a project if $2 million is used to pay interest, the tax rate is 35%, and equity investors require annual income of $4 million? A. $7.40 million B. $8.10 million C. $8.15 million D. $8.85 million AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’t-the appropriate discount rate for a new project. Topic: Project evaluation

85.

What equity proportion should be used when calculating WACC for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity? A. 50.00% B. 54.18% C. 56.55% D. 60.47% We = $65m / [($50m × 0.85) + $65m] = 0.6047, or 60.47%

86.

According to CAPM estimates, what is the cost of equity for a firm with a beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%? A. 19.5% B. 21.0% C. 22.5% D. 24.0% Re = 6% + 1.5(15% − 6) = 19.5%

87.

What return on equity do investors expect for a firm with a $55 share price, an expected dividend of $4.60, a beta of 0.9, and a constant growth rate of 3.5%? A. 9.87% B. 12.48% C. 13.95% D. 11.86% Re = $4.60 / $55 + 0.035 = 0.1186, or 11.86%

88.

Changing the capital structure by adding debt will: A. reduce the return that shareholders require. B. reduce default risk. C. increase debtholder risk. D. reduce the cost of debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-03 Measure a company’s capital structure. Topic: Capital structure

89.

The company cost of capital: A. measures the return that investors require from the company. B. depends on current profits and cash flows. C. is measured using security book values. D. depends on historical profits and cash flows. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of capital-general

90.

XYZ Company issues common stock at a price of $25 a share. The firm expects to pay a dividend of $2.20 a share next year. If the dividend is expected to grow at 2.5% annually, what is XYZ's cost of common equity? A. 6.3% B. 11.3% C. 13.7% D. 8.9% re = $1.20 / $25 + 0.025 = 0.113, or 11.3%

91.

Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5% and the return on the market is 13.6%. A. 11.54% B. 13.08% C. 16.18% D. 18.02% rr = 0.05 + 1.3(0.136 − 0.05) = 0.1618, or 16.18%

92.

Plasti-tech Inc. is financed 60% with equity and 40% with debt. Currently, its debt has a pretax interest rate of 12%. Plastitech's common stock trades at $15.00 per share and its most recent dividend was $1.00. Future dividends are expected grow by 4%. If the tax rate is 34%, what is Plasti-tech's WACC? A. 7.39% B. 9.57% C. 9.73% D. 11.20% re = [($1 × 1.04) / $15] + 0.04 = 0.1093, or 10.93% WACC = 0.4[0.12(1 − 0.34)] + 0.6(0.1093) = 0.0973, or 9.73%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 13-01 Calculate the weighted average cost of capital. Topic: Weighted-average cost of capital

93.

The capital structure for the CR Corporation includes bonds valued at $5,500 and common stock valued at $11,000. If CR has an after-tax cost of debt of 6%, and a cost of common stock of 16%, what is its WACC? A. 9.33% B. 12.67% C. 13.33% D. 14.67% WACC = [($5,500 / $16,500) × 6%] + [($11,000 / $16,500) × 16%] = 12.67%

94.

What is the yield to maturity on Dotte Inc.'s bonds if its after-tax cost of debt is 10% and its tax rate is 35%? A. 6.50% B. 13.50% C. 15.38% D. 16.42% 0.10 = rd(1 − 0.35); rd = 15.38%

95.

Increasing debt financing will do all of the following except: A. cause investors to demand a higher interest rate on debt. B. increase the risk to the firm's common stockholders. C. cause stockholders to demand a higher return. D. decrease the firm's cost of common equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-04 Estimate the expected returns on a firm’s securities. Topic: Cost of equity

96.

Suppose an analyst estimates that free cash flow will be $2.43 million in year 5. What is the present value of this free cash flow if the company cost of capital is 12%, the WACC is 10%, and the equity cost of capital is 15%? A. $2,113,043 B. $1,208,139 C. $1,508,839 D. $1,378,847 PV = $2.43m / 1.105 = $1,508,839

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Topic: Firm valuation

97.

WACC can be used to determine the value of a firm by discounting the firm's: A. after-tax net profits. B. pretax profits. C. cash inflows. D. free cash flows. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 13-05 Use the weighted-average cost of capital to value a business given forecasts of its future cash flows. Topic: Firm valuation

Chapter 13 Test bank - Static Summary Category AACSB: Analytical Thinking

# of Questions 46

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 13-01 Calculate the weighted average cost of capital.

Learning Objective: 13-02 Understand when the weighted-average cost of capital is-or isn’tthe appropriate discount rate for a new project.

Learning Objective: 13-03 Measure a company’s capital structure.

Learning Objective: 13-04 Estimate the expected returns on a firm’s securities.

Learning Objective: 13-05 Use the weightedaverage cost of capital to value a business given forecasts of its future cash flows.

Topic: Capital structure

Topic: Capital structure weights

Topic: Cash flows

Topic: Cost of capital-general

Topic: Cost of debt

Topic: Cost of equity

Topic: Cost of preferred stock

Topic: Divisional and project costs of capital

Topic: Firm valuation

Topic: Project evaluation

Topic: Weighted-average cost of capital

Chapter 14 Test bank - Static Student: ___________________________________________________________________________

Only a portion of the board of directors are up for election in any given year when a firm has a classified board. True

Shares of stock that have been issued and subsequently repurchased by the issuer are known as treasury stock. True

False

Ford Motor Company and Google have issued two classes of shares with different voting rights to allow their firms to obtain fresh capital without giving up their management's controlling rights. True

False

The gap between internally generated cash and the cash that the company needs is called the financial deficit. True

False

Historically, internally generated cash covers less than half of the non-financial firms' capital requirements in the U.S. True

False

In proxy contests, outsiders compete with the firm's existing management and directors for control of the corporation. True

False

Firms tend to issue more debt when internal funds are low. True

False

The price at which new shares are sold to investors almost always exceeds par value. The difference is entered into the company's accounts as additional paid-in capital, or capital surplus. True

False

10. If an incompetent management team controls a large block of votes, it may use these votes to stay in control. True

False

11. Companies sometimes sell the cash flows from a bundle of loans. Such bonds are known as asset-backed bonds. True

False

12. Firms have the right to resell any Treasury stock they own. True

False

13. Different classes of stock often have different voting rights. True

False

14. If shareholders do not like the policies that management pursues, they can vote in a different board of directors. True

False

15. A majority of a firm's directors must be independent of the firm's management. True

False

16. Corporate investors are indifferent between investing in common and preferred shares. True

False

17. If you are concerned with maintaining the market value of your preferred stock, you should purchase floating-rate preferred shares. True

False

18. A convertible bond generally has a higher market value than a comparable non-convertible bond. True

False

19. A corporation cannot default on funded debt. True

False

20. Dividends represent an important component of a firm's net book value. True

False

21. The price at which new shares are issued is referred to as the par value of the stock. True

False

22. A capital surplus is created when the selling price of new shares is greater than the par value. True

False

23. Declassification of a firm's board tends to increase the market value of the firm's stock. True

False

24. The term "senior debt" refers only to debt that was issued in the more distant past. True

False

25. In a bankruptcy situation, funded debt will be repaid while unfunded debt will not. True

False

26. Holders of callable bonds know that the company will wish to buy the issue back if interest rates fall, and therefore the price of the bond will not rise above the call price. True

False

27. Callable bonds may be repurchased by the issuing firm before maturity at the specified call price. True

False

28. The call provision of callable bonds comes at the expense of bond holders, for it limits their capital gain potential. True

False

29. Bonds with the callable feature tend to sell at lower prices than bonds without such a feature. True

False

30. A eurobond is defined as any bond that is denominated in euros. True

False

31. For most firms, the majority of their funding is from external sources. True

False

32. Privately placed debt must be held until maturity and can never be resold. True

False

33. When firms retain cash, they are generating funds internally thereby decreasing the amount of external funds needed. True

False

34. Floating-rate bonds appeal to investors who are worried about fluctuations in interest rates. True

False

35. A stock's par value is the: A. maturity value of the stock. B. price at which each share is recorded. C. price at which an investor could sell the stock. D. price received by the firm when the stock was issued. 36. Additional paid-in capital refers to: A. a firm's retained earnings. B. a firm's treasury stock. C. the difference between the issue price and the par value. D. funds borrowed from a bank or bondholders.

37. Which one of the following equity concepts would you expect to be least important to a financial analyst? A. Par value per share B. Additional paid-in capital C. Retained earnings D. Net common equity 38. Any capital surplus shown by a firm on its balance sheet results from: A. not paying out all net income as dividends. B. repurchasing shares for treasury stock. C. issuing stock at a price higher than par value. D. retained earnings. 39. How much will be recorded as a firm's additional paid-in capital if the firm issues 1 million shares that have a $5 par value for $15 per share? A. $0 B. $5 million C. $10 million D. $15 million 40. If a corporation issues 1,000 shares of $1 par value stock for $10 per share, then retained earnings will: A. increase by $1,000. B. increase by $9,000. C. decrease by $9,000. D. remain unchanged. 41. Assume a firm with 5,000 shares outstanding earns $10 per share and has a 30% plowback ratio. In this case retained earnings will: A. increase by $15,000. B. increase by $50,000. C. decrease by $15,000. D. decrease by $50,000. 42. What is the book value per share of equity for a firm with $1 million in net common equity, $50,000 in authorized share capital, 25,000 shares issued, and 20,000 shares outstanding? A. $38.00 B. $40.00 C. $47.50 D. $50.00 43. Assume a corporation has cumulative voting and there are two directors up for election. What is the maximum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A. 20 B. 40 C. 100 D. 200

44. Assume a corporation has cumulative voting and there are two directors up for election. What is the minimum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A. 0 B. 20 C. 40 D. 100 45. A proxy contest is typically one in which: A. the Board attempts to gain control from the shareholders. B. management attempts to gain control from the Directors. C. outsiders attempt to gain control from management. D. the Board attempts to gain control from the Directors. 46. A corporation's net worth is composed of the: A. book value of common equity plus par value of debt. B. par value plus additional paid-in capital. C. retained earnings less treasury stock. D. book value of common equity plus preferred stock. 47. Preferred stock dividends: A. have preference over bond interest payments. B. are guaranteed to be paid at least annually. C. are excluded from the taxable income of their recipients. D. have priority over common stock dividends. 48. If a corporation receives $50,000 in preferred stock dividends, how much tax does it pay on these dividends? The corporate tax rate is 35%.

A. $0 B. $5,250 C. $12,250 D. $17,500 49. Which one of the following statements about floating-rate preferred stock is correct? A. Its dividends increase as interest rates increase. B. Its market price increases at a set rate annually. C. It is the only stock issued without a par value. D. Its dividends are deductible for tax purposes by the paying corporation. 50. Funded debt refers to those liabilities that: A. have established a sinking fund for repayment. B. are not callable at the option of the firm. C. are secured by specific collateral. D. have a maturity of more than one year remaining.

51. The purpose of a sinking fund is to: A. reduce the par value of stock over time. B. take advantage of the tax break on preferred stock. C. periodically retire debt prior to final maturity. D. allow risky corporations to avoid bankruptcy. 52. Warrants: A. allow their holder to purchase shares at the current market price. B. have a guaranteed maturity value. C. grant the option to purchase either stocks or bonds at the holders discretion. D. have an expiration date. 53. Which one of these terms applies to the bundling of a group of loans with the subsequent sale of the cash flows from those loans? A. Convertible bond B. Warrants C. Asset-backed bond D. Preferred bond 54. Eurobonds are long-term, corporate liabilities that: A. are issued by European firms. B. must be held inside the United States by foreigners. C. are marketed in many countries. D. are repaid in U.S. dollars. 55. Bonds that have been sold only to a limited number of institutional investors are considered: A. secured bonds. B. convertible bonds. C. private placements. D. indexed bonds. 56. Which one of these accounts represents internal funding? A. Retained earnings B. Common stock C. Bonds payable D. Preferred stock 57. A warrant grants its holder the right to do which one of these prior to a specified date? A. Convert debt into a specified number of shares B. Sell common shares at a predetermined price C. Exchange stock for bonds at a specified price D. Purchase shares at a predetermined price

58. What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of stock that are currently selling for $80 per share? A. The bondholder will lose $100. B. The stock will go down to $50 per share. C. The bond's price will go down to $900. D. The bondholder will choose to convert. 59. What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of stock that are currently selling for $45 per share? A. The bondholders will choose to convert. B. The stock will go up to $50 per share. C. The bond's price will go down to $900. D. Bondholders will not convert. 60. Convertible bonds resemble a combination of which two types of securities? A. Investment grade bonds and junk bonds B. Bonds and common stock C. Bonds and warrants D. Bonds and preferred stock 61. What is the most commonly bundled type of loan in the asset-backed bond category? A. Automobile loans B. Mortgages C. Credit card receivables D. Student loans 62. Which one of the following statements is correct? A. A convertible bondholder is forced to convert no later than a pre-specified time. B. The convertible option on a bond gives the owner the right to buy shares from a company at a pre-determined cash price. C. The owner of a warrant has an option to convert the warrant into convertible bonds. D. The owner of a warrant will benefit if the firm's stock does well. 63. An investor might prefer floating-rate debt if she thought that: A. interest rates would rise. B. interest rates would decline. C. its bond rating might be lowered. D. its bonds were going to be converted into equity. 64. If net equity issues have been negative, A. more shares have been repurchased than newly issued. B. new shares have been sold at less than par value. C. issuing stock has been a negative NPV transaction. D. dividend payments have exceeded net income.

65. All of the following are true of retained earnings except: A. They are the difference between paid-in capital and the total dividends paid. B. They represent the amount of new capital shareholders have indirectly contributed. C. They are equal to the cumulative earnings less dividends. D. They are the amount of earnings plowed back into the firm. 66. Jay's Jams Inc. was just established with an investment of $3 million. Jay expects his company to generate free cash flow of $800,000 a year for the next 10 years. If Jay's cost of capital is 15%, find the market value and book value of his company. A. Market value = $8.0 million; book value = $3.0 million B. Market value = $3.0 million; book value = $4.0 million C. Market value = $4.0 million; book value = $3.0 million D. Market value = $8.0 million; book value = $4.0 million 67. Wheat's Market just issued 17,500 new shares of common stock at a price of $20 a share. How will this transaction affect the equity accounts on the firm's balance sheet if the par value is $1 per share? A. The common stock account will increase by $350,000. B. The common stock account will decrease by $17,500. C. Paid in surplus will increase by $332,500. D. Paid in surplus will increase by $350,000. 68. When new shares of stock are sold at a price greater than par value, the excess over par is recorded as: A. capital surplus. B. retained earnings. C. treasury stock. D. authorized capital. 69. A firm just issued 15,000 new shares of stock with a market price of $14 per share and par value of $2 per share. Which one of these correctly states the resulting change in the equity accounts? A. Capital surplus will increase by $180,000. B. Retained earnings will decrease by $210,000. C. Common stock will increase by $15,000. D. Common stock will increase by $210,000. 70. Corporations generally need shareholder approval to do which one of the following? A. Select a new CEO B. Increase the number of authorized shares C. Purchase Treasury stock D. Pay a regular dividend 71. Which statement correctly describes the company’s dividend decision? A. The dividend payment is set by shareholders at the annual general meeting. B. The dividend payment is the sole responsibility of the company’s management. C. The dividend payment must be approved by the board of directors. D. The dividend payment is set by the company’s bondholders together with the shareholders.

72. The value of retained earnings on the corporate balance sheet represents the amount of earnings: A. not paid out in dividends this period. B. that are being held in cash. C. over and above corporate income taxes. D. reinvested in the firm since its inception. 73. Which one of the following statements is typically correct for a going-concern firm? A. Book value of equity exceeds market value of equity. B. Market value of equity exceeds book value of equity. C. Book value of equity equals market value of equity. D. No typical relationship exists between book and market values of equity. 74. A company's board of directors is primarily an agent of the company's: A. management. B. employees. C. shareholders. D. management and employees. 75. The system of electing a board of directors where each director is voted on separately is known as: A. majority voting. B. supermajority voting. C. cumulative voting. D. proxy voting. 76. A shareholder owning 100 shares of stock is voting for the board of directors who are elected by cumulative voting. How many votes will the shareholder cast for Director "A" if four directors are to be elected and the maximum number of votes are cast for "A"? A. 25 B. 100 C. 200 D. 400 77. One way in which control of a corporation can be removed from the current board of directors is to: A. take away the directors' stock. B. give voting power to management. C. remove the Board's voting power. D. fight a proxy contest. 78. One common reason for issuing two distinct classes of common stock is to: A. sell different classes to increase profits. B. allow one stock to increase in price while the other class declines. C. restrict voting privileges from some shareholders. D. conserve cash by offering dividends to only one class of stockholders.

79. Which one of the following statements is correct? A. Common stock dividends cannot be paid if preferred stock dividends are in arrears. B. Preferred stock dividends cannot be paid if common stock dividends are in arrears. C. Common and preferred dividends must be paid simultaneously. D. No dividends on the common stock can be paid without specific shareholder approval. 80. What is the after-tax cost to a corporation in the 35% tax bracket of paying $50,000 in preferred stock dividends? A. $17,500 B. $32,500 C. $50,000 D. $76,923 81. Which one of the following statements is correct about a corporation in the 35% tax bracket that can invest either in a bond paying 8% interest or in the preferred stock of another corporation that pays a 6% dividend? Ignore any differences in risk. A. The preferred stock should be selected because its after-tax yield is 0.17% higher. B. The preferred stock should be selected because its after-tax yield is 0.80% higher. C. The bond should be selected because its after-tax yield is 0.17% lower. D. The bond should be selected because its after-tax yield is 1.3% higher. 82. What is the rationale for saying that the federal government provides a tax subsidy to corporate debtors? A. Interest and principal payments are tax deductible. B. Interest payments are tax deductible. C. Principal payments are tax deductible. D. Seventy percent of interest payments are tax deductible. 83. Which one of the following statements is correct about a floating interest rate loan if the interest rate is defined as "Prime plus 1 percent"? The interest rate: A. is set to vary at a rate equal to the prime rate plus 1 percent. B. can fluctuate up to a maximum of 1% above the current prime rate over the life of the loan. C. will be fixed at the current prime rate plus 1 percent. D. will vary with the prime rate but changes will only occur in 1 percent intervals. 84. Corporations that annually retire a set portion of their long-term debt are said to be using: A. indexed bonds. B. sinking funds. C. convertible debt. D. secured debt. 85. An independent outside director: A. is defined as a company employee who has no management responsibilities outside of the board. B. cannot serve as the board chairman. C. is prohibited from owning shares of the firm. D. can be a shareholder as long as he/she holds no management position in the firm outside of the board.

86. If a corporation has more shares issued than outstanding, then: A. the Board of Directors is holding shares. B. there are preferred shares outstanding. C. the corporation has treasury stock. D. unexercised stock warrants exist. 87. Which one of the following statements is true with respect to financial and product markets? A. In product markets, companies rarely find investments that yield a positive NPV. B. Financial markets face fast-moving competition. C. Competition in financial markets is not as thorough as in product markets. D. Competition in product markets is more intense than in financial markets. 88. A warrant has an exercise price of $40, and the current stock price is $38. An investor holding this option will purchase the stock only if the: A. dividend yield on the stock exceeds 10%. B. stock price falls below $38. C. stock price rises above $40. D. stock price falls to $20 or below. 89. Which one of these statements describes U.S. firms during recent years? A. Firms have rarely relied on debt financing. B. Internal funds have provided less than half of the firms financing needs. C. Firms have repurchased more equity than they have sold. D. Debt is used to fund approximately half of the firms financing needs. 90. A firm's internally generated funds are calculated by: A. subtracting depreciation from net income. B. adding depreciation to net income. C. adding dividends to net income. D. subtracting dividends from net income plus depreciation. 91. If 100 million shares of common stock are issued with a par value of $2 and additional paid in capital is $800 million, the total par value of the issued shares is: A. $200 million. B. $600 million. C. $800 million. D. $1 billion. 92. A company is about to issue 1,000 new shares of stock at a market price of $33 per share. If the par value per share is $4, the increase in capital surplus from this stock issue will be: A. $33,000. B. $4,000. C. $29,000. D. $32,000.

93. One way that investors contribute capital to the firm is by: A. the company plowing back part of its earnings. B. paying less than par value for the stock. C. letting their warrants expire unexercised. D. increasing the amount of treasury stock. 94. When a firm issues 50,000 shares with a par value of $5 and a market price of $22 per share, additional paid in capital will: A. decrease by $250,000. B. increase by $250,000. C. increase by $850,000. D. increase by $1,100,000. 95. If the Beta Co. issues $100 million worth of preferred stock, what will happen to its net worth if book value of common equity is $500 million? A. It will increase by $400 million. B. It will decrease by $100 million. C. It will increase to $600 million. D. It will decrease to $400 million. 96. Preferred stockholders generally: A. have full voting rights. B. receive a fixed dividend. C. have priority over debt holders if the company goes bankrupt. D. convert to bond holders. 97. All of the following are types of innovative bonds except: A. preferred stock. B. asset-backed bonds. C. collateralized debt obligations (CDOs). D. mortality bonds. 98. The majority of an established firm's capital is generated: A. internally. B. externally. C. through issuance of new shares. D. through funded debt. 99. Earnings this year for Plasti-tech Inc. were $200,000. It decided to plow back $60,000 and recorded $20,000 of depreciation. Plasti-tech's internally generated funds are: A. $40,000. B. $60,000. C. $80,000. D. $140,000.

100. With respect to bonds, when interest rates increase typically: A. the coupon rate on existing bonds also increases. B. the coupon rate on existing bonds remains unchanged. C. bond prices also increase. D. bond prices remain constant. 101. How does competition in financial markets compare to the competition that can be found in product markets? A. Financial markets are more competitive. B. Financial markets are less competitive. C. Both markets are similar in competition. D. Financial markets are not competitive, due to regulation. 102. To state that financing at current market terms is a zero-NPV transaction indicates that: A. firms should avoid these methods of financing. B. there is no cost involved in the financing. C. the market has not set financing terms correctly. D. there are no "bargains" when financing at current terms. 103. An efficient capital market is one in which: A. all securities that investors desire are offered. B. all transactions are closed within 2 business days. C. current prices reflect all current information. D. the lowest interest rates are offered. 104. Which one of the following is least likely to contribute to the positive-NPV investments found in product markets? A. Patented-production processes B. Financing strategies C. Brand-name product recognition D. Lack of competition 105. If financial markets were not efficient, it would be easier for firms to: A. finance investments in a zero-NPV transaction. B. finance investments in a positive NPV transaction. C. totally avoid the need for external financing. D. finance investments in a negative NPV transaction. 106. The true value of a security is: A. the value of that security at some future date. B. the sum of all future income from that security. C. the amount of funds invested to date in the security. D. the price that incorporates all currently available information.

Chapter 14 Test bank - Static Key 1.

Only a portion of the board of directors are up for election in any given year when a firm has a classified board. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

Shares of stock that have been issued and subsequently repurchased by the issuer are known as treasury stock. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

The price at which new shares are sold to investors almost always exceeds par value. The difference is entered into the company's accounts as additional paid-in capital, or capital surplus. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

Firms tend to issue more debt when internal funds are low. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: Debt

In proxy contests, outsiders compete with the firm's existing management and directors for control of the corporation. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember

Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

Historically, internally generated cash covers less than half of the non-financial firms' capital requirements in the U.S. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: External financing need

The gap between internally generated cash and the cash that the company needs is called the financial deficit. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: External financing need

Ford Motor Company and Google have issued two classes of shares with different voting rights to allow their firms to obtain fresh capital without giving up their management's controlling rights. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Classes of stock

Suppose a firm needs fresh capital, but its management does not want to give up its controlling interest. The existing shares could be labeled Class A, and then Class B shares with limited voting rights could be issued to outside investors. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Classes of stock

10.

If an incompetent management team controls a large block of votes, it may use these votes to stay in control. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

11.

Companies sometimes sell the cash flows from a bundle of loans. Such bonds are known as asset-backed bonds. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond types

12.

Firms have the right to resell any Treasury stock they own. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Balance Sheet

13.

Different classes of stock often have different voting rights. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Classes of stock

14.

If shareholders do not like the policies that management pursues, they can vote in a different board of directors. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

15.

A majority of a firm's directors must be independent of the firm's management. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters.

Topic: Ethics, governance, and regulation

16.

Corporate investors are indifferent between investing in common and preferred shares. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

17.

If you are concerned with maintaining the market value of your preferred stock, you should purchase floating-rate preferred shares. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

18.

A convertible bond generally has a higher market value than a comparable non-convertible bond. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Convertible securities

19.

A corporation cannot default on funded debt. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond types

20.

Dividends represent an important component of a firm's net book value. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

21.

The price at which new shares are issued is referred to as the par value of the stock. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

22.

A capital surplus is created when the selling price of new shares is greater than the par value. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

23.

Declassification of a firm's board tends to increase the market value of the firm's stock. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

24.

The term "senior debt" refers only to debt that was issued in the more distant past. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

25.

In a bankruptcy situation, funded debt will be repaid while unfunded debt will not. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bankruptcy

26.

Holders of callable bonds know that the company will wish to buy the issue back if interest rates fall, and therefore the price of the bond will not rise above the call price. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond valuation

27.

Callable bonds may be repurchased by the issuing firm before maturity at the specified call price. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond features

28.

The call provision of callable bonds comes at the expense of bond holders, for it limits their capital gain potential. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond yields and returns

29.

Bonds with the callable feature tend to sell at lower prices than bonds without such a feature. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond valuation

30.

A eurobond is defined as any bond that is denominated in euros. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond types

31.

For most firms, the majority of their funding is from external sources. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: External financing need

32.

Privately placed debt must be held until maturity and can never be resold. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Private placements and leveraged buyouts

33.

When firms retain cash, they are generating funds internally thereby decreasing the amount of external funds needed. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: External financing need

34.

Floating-rate bonds appeal to investors who are worried about fluctuations in interest rates. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond types

35.

A stock's par value is the: A. maturity value of the stock. B. price at which each share is recorded. C. price at which an investor could sell the stock. D. price received by the firm when the stock was issued. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements.

Topic: Balance Sheet

36.

Additional paid-in capital refers to: A. a firm's retained earnings. B. a firm's treasury stock. C. the difference between the issue price and the par value. D. funds borrowed from a bank or bondholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

37.

Which one of the following equity concepts would you expect to be least important to a financial analyst? A. Par value per share B. Additional paid-in capital C. Retained earnings D. Net common equity AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Financial statement analysis

38.

Any capital surplus shown by a firm on its balance sheet results from: A. not paying out all net income as dividends. B. repurchasing shares for treasury stock. C. issuing stock at a price higher than par value. D. retained earnings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

39.

How much will be recorded as a firm's additional paid-in capital if the firm issues 1 million shares that have a $5 par value for $15 per share? A. $0 B. $5 million C. $10 million D. $15 million Additional paid-in capital = 1m($15 − 5) = $10m

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

40.

If a corporation issues 1,000 shares of $1 par value stock for $10 per share, then retained earnings will: A. increase by $1,000. B. increase by $9,000. C. decrease by $9,000. D. remain unchanged. Issuing new shares does not affect retained earnings.

41.

Assume a firm with 5,000 shares outstanding earns $10 per share and has a 30% plowback ratio. In this case retained earnings will: A. increase by $15,000. B. increase by $50,000. C. decrease by $15,000. D. decrease by $50,000. Change in retained earnings = 5,000 × $10 × 0.30 = $15,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

42.

What is the book value per share of equity for a firm with $1 million in net common equity, $50,000 in authorized share capital, 25,000 shares issued, and 20,000 shares outstanding? A. $38.00 B. $40.00 C. $47.50 D. $50.00 Book value per share = $1m / 20,000 = $50

43.

Assume a corporation has cumulative voting and there are two directors up for election. What is the maximum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A. 20 B. 40 C. 100 D. 200 Maximum votes = 100 × 2 = 200 votes

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

44.

Assume a corporation has cumulative voting and there are two directors up for election. What is the minimum number of votes a shareholder who owns 100 shares can cast for Candidate Jones if there are a total of 5 candidates? A. 0 B. 20 C. 40 D. 100 Minimum votes = 0

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

45.

A proxy contest is typically one in which: A. the Board attempts to gain control from the shareholders. B. management attempts to gain control from the Directors. C. outsiders attempt to gain control from management. D. the Board attempts to gain control from the Directors. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

46.

A corporation's net worth is composed of the: A. book value of common equity plus par value of debt. B. par value plus additional paid-in capital. C. retained earnings less treasury stock. D. book value of common equity plus preferred stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

47.

Preferred stock dividends: A. have preference over bond interest payments. B. are guaranteed to be paid at least annually. C. are excluded from the taxable income of their recipients. D. have priority over common stock dividends. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

48.

If a corporation receives $50,000 in preferred stock dividends, how much tax does it pay on these dividends? The corporate tax rate is 35%. A. $0 B. $5,250 C. $12,250 D. $17,500 Tax liability = $50,000 × 0.30 × 0.35 = $5,250

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

49.

Which one of the following statements about floating-rate preferred stock is correct? A. Its dividends increase as interest rates increase. B. Its market price increases at a set rate annually. C. It is the only stock issued without a par value. D. Its dividends are deductible for tax purposes by the paying corporation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

50.

Funded debt refers to those liabilities that: A. have established a sinking fund for repayment. B. are not callable at the option of the firm. C. are secured by specific collateral. D. have a maturity of more than one year remaining. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Debt

51.

The purpose of a sinking fund is to: A. reduce the par value of stock over time. B. take advantage of the tax break on preferred stock. C. periodically retire debt prior to final maturity. D. allow risky corporations to avoid bankruptcy. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond features

52.

Warrants: A. allow their holder to purchase shares at the current market price. B. have a guaranteed maturity value. C. grant the option to purchase either stocks or bonds at the holders discretion. D. have an expiration date. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Warrants

53.

Which one of these terms applies to the bundling of a group of loans with the subsequent sale of the cash flows from those loans? A. Convertible bond B. Warrants C. Asset-backed bond D. Preferred bond AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Convertible securities

54.

Eurobonds are long-term, corporate liabilities that: A. are issued by European firms. B. must be held inside the United States by foreigners. C. are marketed in many countries. D. are repaid in U.S. dollars. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Debt

55.

Bonds that have been sold only to a limited number of institutional investors are considered: A. secured bonds. B. convertible bonds. C. private placements. D. indexed bonds. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Private placements and leveraged buyouts

56.

Which one of these accounts represents internal funding? A. Retained earnings B. Common stock C. Bonds payable D. Preferred stock AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

57.

A warrant grants its holder the right to do which one of these prior to a specified date? A. Convert debt into a specified number of shares B. Sell common shares at a predetermined price C. Exchange stock for bonds at a specified price D. Purchase shares at a predetermined price AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Warrants

58.

What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of stock that are currently selling for $80 per share? A. The bondholder will lose $100. B. The stock will go down to $50 per share. C. The bond's price will go down to $900. D. The bondholder will choose to convert. Conversion value = 20 × $80 = $1,800; Bondholders will convert.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Convertible securities

59.

What happens in the case of a bond selling for $1,000 that can be converted to 20 shares of stock that are currently selling for $45 per share? A. The bondholders will choose to convert. B. The stock will go up to $50 per share. C. The bond's price will go down to $900. D. Bondholders will not convert. Conversion value = 20 × $45 = $900; bondholders will not convert.

60.

Convertible bonds resemble a combination of which two types of securities? A. Investment grade bonds and junk bonds B. Bonds and common stock C. Bonds and warrants D. Bonds and preferred stock AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Convertible securities

61.

What is the most commonly bundled type of loan in the asset-backed bond category? A. Automobile loans B. Mortgages C. Credit card receivables D. Student loans AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond types

62.

Which one of the following statements is correct? A. A convertible bondholder is forced to convert no later than a pre-specified time. B. The convertible option on a bond gives the owner the right to buy shares from a company at a pre-determined cash price. C. The owner of a warrant has an option to convert the warrant into convertible bonds. D. The owner of a warrant will benefit if the firm's stock does well. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Warrants

63.

An investor might prefer floating-rate debt if she thought that: A. interest rates would rise. B. interest rates would decline. C. its bond rating might be lowered. D. its bonds were going to be converted into equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond features

64.

If net equity issues have been negative, A. more shares have been repurchased than newly issued. B. new shares have been sold at less than par value. C. issuing stock has been a negative NPV transaction. D. dividend payments have exceeded net income. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Financial statement analysis

65.

All of the following are true of retained earnings except: A. They are the difference between paid-in capital and the total dividends paid. B. They represent the amount of new capital shareholders have indirectly contributed. C. They are equal to the cumulative earnings less dividends. D. They are the amount of earnings plowed back into the firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

66.

Jay's Jams Inc. was just established with an investment of $3 million. Jay expects his company to generate free cash flow of $800,000 a year for the next 10 years. If Jay's cost of capital is 15%, find the market value and book value of his company. A. Market value = $8.0 million; book value = $3.0 million B. Market value = $3.0 million; book value = $4.0 million C. Market value = $4.0 million; book value = $3.0 million D. Market value = $8.0 million; book value = $4.0 million AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Market and book values

67.

Wheat's Market just issued 17,500 new shares of common stock at a price of $20 a share. How will this transaction affect the equity accounts on the firm's balance sheet if the par value is $1 per share? A. The common stock account will increase by $350,000. B. The common stock account will decrease by $17,500. C. Paid in surplus will increase by $332,500. D. Paid in surplus will increase by $350,000. Increase in common stock account = 17,500 × $1 = $17,500 Increase in paid in surplus = 17,500 × ($20 − 1) = $332,500

68.

When new shares of stock are sold at a price greater than par value, the excess over par is recorded as: A. capital surplus. B. retained earnings. C. treasury stock. D. authorized capital. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

69.

A firm just issued 15,000 new shares of stock with a market price of $14 per share and par value of $2 per share. Which one of these correctly states the resulting change in the equity accounts? A. Capital surplus will increase by $180,000. B. Retained earnings will decrease by $210,000. C. Common stock will increase by $15,000. D. Common stock will increase by $210,000. Increase in common stock = 15,000 × $2 = $30,000 Increase in capital surplus = 15,000 × ($14 − 2) = $180,000

70.

Corporations generally need shareholder approval to do which one of the following? A. Select a new CEO B. Increase the number of authorized shares C. Purchase Treasury stock D. Pay a regular dividend AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

71.

Which statement correctly describes the company’s dividend decision? A. The dividend payment is set by shareholders at the annual general meeting. B. The dividend payment is the sole responsibility of the company’s management. C. The dividend payment must be approved by the board of directors. D. The dividend payment is set by the company’s bondholders together with the shareholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Board decisions

72.

The value of retained earnings on the corporate balance sheet represents the amount of earnings: A. not paid out in dividends this period. B. that are being held in cash. C. over and above corporate income taxes. D. reinvested in the firm since its inception. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

73.

Which one of the following statements is typically correct for a going-concern firm? A. Book value of equity exceeds market value of equity. B. Market value of equity exceeds book value of equity. C. Book value of equity equals market value of equity. D. No typical relationship exists between book and market values of equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Market and book values

74.

A company's board of directors is primarily an agent of the company's: A. management. B. employees. C. shareholders. D. management and employees. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Agency costs and problems

75.

The system of electing a board of directors where each director is voted on separately is known as: A. majority voting. B. supermajority voting. C. cumulative voting. D. proxy voting. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

76.

A shareholder owning 100 shares of stock is voting for the board of directors who are elected by cumulative voting. How many votes will the shareholder cast for Director "A" if four directors are to be elected and the maximum number of votes are cast for "A"? A. 25 B. 100 C. 200 D. 400 Maximum votes with cumulative voting = 4 × 100 = 400

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

77.

One way in which control of a corporation can be removed from the current board of directors is to: A. take away the directors' stock. B. give voting power to management. C. remove the Board's voting power. D. fight a proxy contest. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters. Topic: Shareholder voting

78.

One common reason for issuing two distinct classes of common stock is to: A. sell different classes to increase profits. B. allow one stock to increase in price while the other class declines. C. restrict voting privileges from some shareholders. D. conserve cash by offering dividends to only one class of stockholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Classes of stock

79.

Which one of the following statements is correct? A. Common stock dividends cannot be paid if preferred stock dividends are in arrears. B. Preferred stock dividends cannot be paid if common stock dividends are in arrears. C. Common and preferred dividends must be paid simultaneously. D. No dividends on the common stock can be paid without specific shareholder approval. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

80.

What is the after-tax cost to a corporation in the 35% tax bracket of paying $50,000 in preferred stock dividends? A. $17,500 B. $32,500 C. $50,000 D. $76,923 Dividends are paid out of after-tax income.

81.

Which one of the following statements is correct about a corporation in the 35% tax bracket that can invest either in a bond paying 8% interest or in the preferred stock of another corporation that pays a 6% dividend? Ignore any differences in risk. A. The preferred stock should be selected because its after-tax yield is 0.17% higher. B. The preferred stock should be selected because its after-tax yield is 0.80% higher. C. The bond should be selected because its after-tax yield is 0.17% lower. D. The bond should be selected because its after-tax yield is 1.3% higher. Bond after-tax yield = 8%(1 − 0.35) = 5.2% Stock after-tax yield = 6% − (6% × 0.30 × 0.35) = 5.37% Difference = 5.37% − 5.2 = 0.17%; the preferred stock is the better investment.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Tax effects on dividends and payouts

82.

What is the rationale for saying that the federal government provides a tax subsidy to corporate debtors? A. Interest and principal payments are tax deductible. B. Interest payments are tax deductible. C. Principal payments are tax deductible. D. Seventy percent of interest payments are tax deductible. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Tax effects on dividends and payouts

83.

Which one of the following statements is correct about a floating interest rate loan if the interest rate is defined as "Prime plus 1 percent"? The interest rate: A. is set to vary at a rate equal to the prime rate plus 1 percent. B. can fluctuate up to a maximum of 1% above the current prime rate over the life of the loan. C. will be fixed at the current prime rate plus 1 percent. D. will vary with the prime rate but changes will only occur in 1 percent intervals. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond features

84.

Corporations that annually retire a set portion of their long-term debt are said to be using: A. indexed bonds. B. sinking funds. C. convertible debt. D. secured debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond features

85.

An independent outside director: A. is defined as a company employee who has no management responsibilities outside of the board. B. cannot serve as the board chairman. C. is prohibited from owning shares of the firm. D. can be a shareholder as long as he/she holds no management position in the firm outside of the board. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters.

Topic: Ethics, governance, and regulation

86.

If a corporation has more shares issued than outstanding, then: A. the Board of Directors is holding shares. B. there are preferred shares outstanding. C. the corporation has treasury stock. D. unexercised stock warrants exist. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

87.

Which one of the following statements is true with respect to financial and product markets? A. In product markets, companies rarely find investments that yield a positive NPV. B. Financial markets face fast-moving competition. C. Competition in financial markets is not as thorough as in product markets. D. Competition in product markets is more intense than in financial markets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Topic: Market efficiency

88.

A warrant has an exercise price of $40, and the current stock price is $38. An investor holding this option will purchase the stock only if the: A. dividend yield on the stock exceeds 10%. B. stock price falls below $38. C. stock price rises above $40. D. stock price falls to $20 or below. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Warrants

89.

Which one of these statements describes U.S. firms during recent years? A. Firms have rarely relied on debt financing. B. Internal funds have provided less than half of the firms financing needs. C. Firms have repurchased more equity than they have sold. D. Debt is used to fund approximately half of the firms financing needs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: Capital structure observations

90.

A firm's internally generated funds are calculated by: A. subtracting depreciation from net income. B. adding depreciation to net income. C. adding dividends to net income. D. subtracting dividends from net income plus depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: Cash flows

91.

If 100 million shares of common stock are issued with a par value of $2 and additional paid in capital is $800 million, the total par value of the issued shares is: A. $200 million. B. $600 million. C. $800 million. D. $1 billion. Total par value = 100m × $2 = $200m

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements. Topic: Balance Sheet

92.

A company is about to issue 1,000 new shares of stock at a market price of $33 per share. If the par value per share is $4, the increase in capital surplus from this stock issue will be: A. $33,000. B. $4,000. C. $29,000. D. $32,000. Increase in capital surplus = 1,000 × ($33 − 4) = $29,000

93.

One way that investors contribute capital to the firm is by: A. the company plowing back part of its earnings. B. paying less than par value for the stock. C. letting their warrants expire unexercised. D. increasing the amount of treasury stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: Balance Sheet

94.

When a firm issues 50,000 shares with a par value of $5 and a market price of $22 per share, additional paid in capital will: A. decrease by $250,000. B. increase by $250,000. C. increase by $850,000. D. increase by $1,100,000. Increase in paid in capital = 50,000 × ($22 − 5) = $850,000

95.

If the Beta Co. issues $100 million worth of preferred stock, what will happen to its net worth if book value of common equity is $500 million? A. It will increase by $400 million. B. It will decrease by $100 million. C. It will increase to $600 million. D. It will decrease to $400 million. Book value = $100m + 500m = $600m

96.

Preferred stockholders generally: A. have full voting rights. B. receive a fixed dividend. C. have priority over debt holders if the company goes bankrupt. D. convert to bond holders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Preferred stock features

97.

All of the following are types of innovative bonds except: A. preferred stock. B. asset-backed bonds. C. collateralized debt obligations (CDOs). D. mortality bonds. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Bond types

98.

The majority of an established firm's capital is generated: A. internally. B. externally. C. through issuance of new shares. D. through funded debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: Capital structure

99.

Earnings this year for Plasti-tech Inc. were $200,000. It decided to plow back $60,000 and recorded $20,000 of depreciation. Plasti-tech's internally generated funds are: A. $40,000. B. $60,000. C. $80,000. D. $140,000. Internally generated funds = $60,000 + 20,000 = $80,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth. Topic: Cash flows

100.

With respect to bonds, when interest rates increase typically: A. the coupon rate on existing bonds also increases. B. the coupon rate on existing bonds remains unchanged. C. bond prices also increase. D. bond prices remain constant. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-05 Describe the major classes of securities sold by the firm. Topic: Interest rate risk

101.

How does competition in financial markets compare to the competition that can be found in product markets? A. Financial markets are more competitive. B. Financial markets are less competitive. C. Both markets are similar in competition. D. Financial markets are not competitive, due to regulation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Topic: Market efficiency

102.

To state that financing at current market terms is a zero-NPV transaction indicates that: A. firms should avoid these methods of financing. B. there is no cost involved in the financing. C. the market has not set financing terms correctly. D. there are no "bargains" when financing at current terms. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Topic: Market efficiency

103.

An efficient capital market is one in which: A. all securities that investors desire are offered. B. all transactions are closed within 2 business days. C. current prices reflect all current information. D. the lowest interest rates are offered. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Topic: Market efficiency

104.

Which one of the following is least likely to contribute to the positive-NPV investments found in product markets? A. Patented-production processes B. Financing strategies C. Brand-name product recognition D. Lack of competition AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Topic: Market efficiency

105.

If financial markets were not efficient, it would be easier for firms to: A. finance investments in a zero-NPV transaction. B. finance investments in a positive NPV transaction. C. totally avoid the need for external financing. D. finance investments in a negative NPV transaction. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Topic: Market efficiency

106.

The true value of a security is: A. the value of that security at some future date. B. the sum of all future income from that security. C. the amount of funds invested to date in the security. D. the price that incorporates all currently available information. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced. Topic: Market efficiency

Chapter 14 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

106

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

106

Learning Objective: 14-01 Explain why managers should assume that the securities they issue are fairly priced.

Learning Objective: 14-02 Summarize the changing ways that U.S. firms have financed their growth.

Learning Objective: 14-03 Interpret shareholder equity accounts in the firm's financial statements.

Learning Objective: 14-04 Describe voting procedures for the election of a firm's board of directors and other matters.

Learning Objective: 14-05 Describe the major classes of securities sold by the firm.

Topic: Agency costs and problems

Topic: Balance Sheet

Topic: Bankruptcy

Topic: Board decisions

Topic: Bond features

Topic: Bond types

Topic: Bond valuation

Topic: Bond yields and returns

Topic: Capital structure

Topic: Capital structure observations

Topic: Cash flows

Topic: Classes of stock

Topic: Convertible securities

Topic: Debt

Topic: Ethics, governance, and regulation

Topic: External financing need

Topic: Financial statement analysis

Topic: Interest rate risk

Topic: Market and book values

Topic: Market efficiency

Topic: Per-share valuations

Topic: Preferred stock features

Topic: Private placements and leveraged buyouts

Topic: Shareholder voting

Topic: Tax effects on dividends and payouts

Topic: Warrants

Chapter 15 Test bank - Static Student: ___________________________________________________________________________

Equity capital in young businesses is known as venture capital and it is provided by venture capital firms, wealthy individuals, and investment institutions such as pension funds. True

Venture capitalists generally provide sufficient up-front funding in one lump sum to take a new firm to the point where it can go public. True

False

Shelf registration is a procedure that allows firms to file several registration statements for one issue of the security. True

False

When a public company makes a general cash offer of debt or equity, it essentially follows the same procedure used when it first went public. True

False

A consequence of the Sarbanes-Oxley Act has been a decreased reporting burden on small public companies and a decrease in the number of companies reverting to private ownership. True

False

Some successful corporations will provide venture capital to new firms with innovative ideas. True

False

Underwriters usually play a triple role-first providing the company with procedural and financial advice, then buying the stock, and finally reselling it to the public. True

False

In many countries it is common even for large businesses to remain privately owned. True

False

The bookbuilding method used by almost all IPOs in the United States is like an auction, since potential buyers indicate how many shares they are prepared to buy at given prices. True

False

10. The SEC requires the sale of a private placement to be limited to a small number of knowledgeable investors. True

False

11. The advantage of the bookbuilding method is that it allows underwriters to give preference to those investors whose bids are most helpful in setting the issue price and to offer them a reward in the shape of underpricing. True

False

12. When securities are issued under a firm commitment, the underwriter bears the risk of low demand from investors. True

False

13. The SEC reviews the registration statement and determines whether or not an investment in the firm is advisable. True

False

14. Like a general cash offering, a rights issue is an offer to buy shares made to existing and potential shareholders. True

False

15. In a rights offering, the shares are priced at a substantial discount to current market value, which ensures that the shareholders will either exercise the rights themselves or sell them to other investors. True

False

16. Shelf registration is used more frequently for equity financing than for debt financing. True

False

17. An average-sized firm should expect the underwriting and administrative costs of going public to be around 7% to 8% of the IPO proceeds. True

False

18. Issue costs for debt are considerably lower than issue costs for equity securities. True

False

19. The evidence indicates that industrial stock prices in the U.S. decrease by approximately 3%, on average, when new equity issues are announced. True

False

20. Firms are attracted to the private placement of debt because of the lower average interest rates. True

False

21. The contract between the underwriter and the issuing company is known as the new issue prospectus. True

False

22. IPOs are generally overpriced in order to raise large amounts of cash. True

False

23. The winner's curse theory assumes that the informed investor receives more of the underpriced IPOs. True

False

24. Privately placed securities may be difficult to resell. True

False

25. A rights issue is one in which a public company offers shares only to existing shareholders in order to raise additional cash. True

False

26. Crowdfunding is primarily used as a means for a publicly-traded company to raise additional capital. True

False

27. A general cash offer is necessary when issuing a private placement. True

False

28. Private placement contracts may be custom tailored for firms with special needs or unique opportunities. True

False

29. One advantage to private placements is the low cost. True

False

30. Private placements tend to be made by smaller firms that usually incur the highest costs when issuing public securities. True

False

31. Money that is offered to finance a new business is known as: A. a general cash offer. B. venture capital. C. a private placement. D. a rights issue. 32. An investor exercises the right to buy one additional share at $20 for every five shares held. How much should each share be worth after the rights issue if they previously sold for $50 each? A. $35.00 B. $41.67 C. $45.00 D. $46.00 33. A firm's first offering of stock to the general public is known as: A. first-stage financing. B. an IPO. C. a general cash offer. D. a seasoned offering.

34. A secondary offering IPO occurs when: A. new shares are sold to provide the company with additional funds. B. the second public issue of equity becomes available. C. the company's founders or venture capitalists market a portion of their shares. D. not all of the shares in a primary IPO were sold. 35. The most important function of an underwriter is to:

A. assess the firm's capital needs. B. approve the prospectus before distribution to the public. C. provide private placement of the firm's debt. D. buy the securities issue from the firm and resell the securities to the public. 36. When underwriters issue securities on a best efforts basis, they: A. sell as much of the stock as possible, but with no guarantee. B. submit a bid for purchase, which the issuer compares to other bids. C. buy the entire issue from the firm. D. guarantee that the issuer will be charged the minimum spread. 37. If an underwriter charges the public $40 per share for a new issue after having promised the issuer $38 per share, the spread per share is:

A. $1. B. $2. C. $38. D. $40. 38. When underwriters are unsure of the demand for a new offering, they: A. reduce their spread. B. undertake the issue on a firm commitment basis. C. undertake the issue on a best efforts basis. D. provide shelf registration for the issue. 39. A major purpose of the prospectus is to: A. inform investors of the security's rate of return. B. advise investors of the security's potential risks. C. distribute stock warrants to prospective investors. D. list the security's dividend payment dates. 40. Studies have shown that, on average, new security issues are: A. subject to flotation costs of approximately 32%. B. overpriced by the amount of the spread. C. underpriced. D. overpriced to reward venture capitalists.

41. One reason that underpricing of new issues occurs more frequently than overpricing is that: A. underwriters want to reduce the risk of a firm commitment. B. the demand for a new issue is typically too high. C. underwriters earn low rates of return. D. issuing firms demand that equity be underpriced. 42. How much will a firm receive in net funding from a firm commitment underwriting of 250,000 shares priced to the public at $40 if a 10% underwriting spread has been added to the price paid by the underwriter? Additionally, the firm pays $600,000 in legal fees. A. $8,400,000 B. $8,460,025 C. $8,490,909 D. $8,545,455 43. One reason for an underwriters' syndication is to: A. monitor the actions of the different underwriters. B. reduce the risk of selling a large issue. C. increase the size of the spread. D. avoid the scrutiny of the Securities and Exchange Commission. 44. Who bears the bulk of the cost of underpricing an IPO? A. The underwriters B. The investors who purchase IPO shares C. All of the after-IPO shareholders D. The pre-IPO shareholders 45. An IPO was offered to the public at $18 a share with the issuing firm receiving $16.50 of that amount. The issuer incurred $750,000 in legal and administrative costs. At the end of the first trading day, the stock was priced at $22.40 a share. What was the total dollar cost, including both direct and indirect costs, of issuing the securities if 225,000 shares were offered? A. $1,687,500 B. $1,540,000 C. $2,077,500 D. $1,087,500 46. The consent of a corporation's stockholders must be received prior to any: A. issue of new securities. B. selection of an underwriter. C. increase in authorized capital. D. private placement of securities.

47. When securities are issued under a rights issue: A. existing shareholders have the opportunity to expand their holdings. B. shares are offered to the public at a discount. C. the existing shares will increase in price. D. current shareholders have the right to resell their stock to the issuer. 48. What would you expect to be the market price of stock after a sold-out rights issue, if each existing shareholder purchases one new share at $60 for each three that he or she currently holds, and the current share price is $100? A. $75 B. $80 C. $85 D. $90 49. What was the market price of a share of stock before a rights issue, if one share of new stock could be purchased at $100 for every four shares that were previously owned? The stock price after the successful rights issue was $200. A. $220 B. $225 C. $240 D. $250 50. Which one of these terms applies to a public company offering new shares to the general public? A. Rights offer B. Initial public offering C. Venture capital offer D. General cash offer 51. Shelf registration was enacted to allow: A. the Department of Justice to prosecute those guilty of insider trading. B. the prospectus to be distributed after the sale of securities begins. C. underwriters to join together in syndication. D. a joint filing for multiple issues of a single security. 52. Which one of the following would not be included among the benefits of shelf registration? A. Reduction of lead time for security issuance B. No additional registration necessary for 5 years C. Issuer can take advantage of favorable conditions D. Issuer can search for best underwriting terms 53. The enactment of shelf registration is likely to have increased: A. the cost of issuing new securities. B. the interests of venture capitalists. C. competition among underwriters. D. the underpricing of securities.

54. If a corporation's management, with its superior knowledge of proposed investments, considers a security issue to be underpriced, it may react by: A. forgoing the security issuance and investment. B. lowering the price of the existing shares to equal the new shares. C. increasing the number of shares to be sold. D. adopting shelf registration, which automatically raises the issue price. 55. If a new stock offering were overpriced and could be sold, then the: A. existing shareholders would benefit. B. new investors would gain at the expense of the existing shareholders. C. firm could avoid the underwriting spread. D. firm could avoid the SEC filing. 56. Issue costs for equity are higher than those for debt for all of the following reasons except: A. equity issues have higher administrative costs. B. underwriting stock is riskier than underwriting bonds. C. equity issues involve significantly more time to sell. D. equity issues have no economies of scale. 57. A firm has just issued $250 million of equity which caused its stock price to drop by 3%. Calculate the loss in value of the firm's equity given that its market value of equity was $1 billion before the new issue. A. $7.5 million B. $30.0 million C. $33.3 million D. $37.5 million 58. Companies offering smaller security issues may prefer to issue them through a: A. private placement because lower rates of return can be offered. B. private placement because it is cheaper than a public issue. C. public issue because it is cheaper than a private placement. D. public issue because more exposure will be achieved. 59. Which one of the following statements is incorrect concerning private placements? A. Terms of the financing can be custom-tailored. B. The securities are not made available to the public. C. The securities are often less marketable. D. Only a small amount of corporate debt is financed in this manner. 60. Private placement of debt securities occurs more frequently in: A. smaller-sized firms. B. larger-sized firms. C. firms that are using venture capitalists. D. combination with convertible bonds.

61. In return for providing funds, venture capitalists generally require: A. collateral equal in value to the funds provided. B. first right to all of the firm's assets. C. an equity position in the firm. D. ownership of the entire firm. 62. Which one of the following is least likely to explain why entrepreneurs contribute their personal funds to start-up projects? Their contribution: A. acts as a signal to venture capitalists. B. repays debt held by the venture capitalist. C. retains a portion of the firm's equity. D. provides incentive to expend effort. 63. What is the market value placed on a firm in which an entrepreneur invests $1 million and a venture capitalist invests $3 million in first-stage financing for a 50% interest in the firm? A. $4 million B. $6 million C. $7 million D. $8 million 64. Second-stage financing occurs: A. prior to the initial public offering. B. when company founders sell a portion of their shares. C. after the best efforts of the underwriters. D. when the IPO does not raise sufficient cash. 65. One of the primary reasons for disbursing venture capital funds in installments is to: A. avoid tax liability. B. identify and cut losses early. C. increase the importance of the venture capitalist. D. take advantage of the time value of money. 66. Roadshows: A. give companies an opportunity to thank investors who have bought the new issue. B. describe the meetings that managers have with investment bankers to select the underwriter to an issue. C. provide underwriters and the company’s management an opportunity to meet potential investors. D. describe the meetings that management has with the SEC to finalize the issue prospectus. 67. Stock underwriters are: A. investors seeking low prices. B. regulatory agencies that evaluate equity offerings. C. the firm's founders who guarantee a stock's performance. D. investment banking firms that manage security offerings.

68. When underwriters offer a firm commitment on a stock issue, they: A. employ their best efforts in selling the stock. B. guarantee the net proceeds to the issuing firm. C. agree to purchase the venture capitalists' shares. D. assure purchasers that the stock will appreciate. 69. Which one of the following is correct for stock issued under a firm commitment where the underwriter is to receive a spread of 8%? A. The underwriter's profits are guaranteed to be 8%. B. The underwriter must sell at least 92% of the shares. C. The underwriter receives 8% of all shares. D. The underwriter may suffer a loss on the issue. 70. An underwriter enters into a firm commitment to sell 1 million shares at $20 each, including a $2 spread. How much does the issuing firm receive if only 500,000 shares are sold? A. $9 million B. $10 million C. $18 million D. $20 million 71. An underwriter sells 2 million shares of stock to the public at $40 per share. The issuing firm receives $73 million before nonunderwriting costs. A. The underwriter's spread was 2.14%. B. The underwriter’s spread was $40. C. The underwriter’s spread was 8.75%. D. The underwriter’s spread was 9.59%. 72. Blue-sky laws exist in order to: A. protect stock underwriters from fraudulent firms. B. restrict the amount of profit from IPOs. C. control the amount of stock owned by one investor. D. protect investors from deceptive firms. 73. The Securities and Exchange Commission will not permit securities to be sold: A. if they have been overpriced. B. prior to approval of the registration statement. C. unless the issuer guarantees their value. D. until a shelf registration exists. 74. Prospective investors are advised of a stock's potential risks by the: A. underwriter. B. underpricing laws. C. prospectus. D. initial public offering.

75. One way to reduce the risk of marketing a stock is for the underwriter to: A. offer a firm commitment on the issue. B. set the initial stock price below its true value. C. sell the securities in foreign countries. D. offer price rebates on the stock purchases. 76. The "winner's curse" is a reminder that: A. successful bidders may often overpay for an object. B. underwriters charge excessive fees. C. stocks are much riskier than bonds. D. underpricing an issue is a cost to existing owners. 77. The direct expense of a stock issue includes the: A. cost of underpricing the stock. B. underwriting spread and other expenses. C. underwriting spread, other expenses, and cost of underpricing. D. underwriting spread. 78. What direct expense is required to market stock if the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each? A. 6.98% B. 7.19% C. 7.75% D. 8.33% 79. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the cost of underpricing? A. $81 million B. $91 million C. $101 million D. $111 million 80. Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the total cost of issuing the securities? A. $81 million B. $91 million C. $101 million D. $111 million

81. Assume an issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. In percentage terms, how much of the day's closing market value was absorbed by the total costs associated with the issue? A. 13.33% B. 23.33% C. 33.33% D. 43.33% 82. Stock that is sold through a rights issue: A. is offered for cash to the general investing public. B. will not affect the market price of the shares. C. is limited to sales to existing shareholders. D. must be sold on a firm commitment basis. 83. What is the primary reason for a reduction in share value after a successful rights issue? The new shares: A. have higher underwriting expenses. B. are offered at attractive prices. C. reduce the firm's return on equity. D. do not include voting rights. 84. A rights issue offers the firm's shareholders one new share of stock at $40 for every three shares of stock they currently own. What should be the stock price after the rights issue if the stock sells for $80 per share before the issue? A. $56.67 B. $60.00 C. $70.00 D. $71.33 85. Shelf registration allows firms to: A. purchase securities for up to 2 years without registration. B. incur only short time delays in selling securities. C. wait for 2 years before paying for securities. D. offer rights issues to the general public. 86. Which one of the following statements is generally true concerning the costs of issuing securities? A. Underpricing is rarely a significant cost. B. Legal and other administrative costs generally average less than $1 million. C. Debt is cheaper to issue than equity. D. There are no economies of scale in security issuance. 87. Some investors believe that the decision by management to issue equity as opposed to issuing debt is a signal that: A. the stock is currently undervalued. B. the stock is currently overvalued. C. the firm will avoid dilution of stock value. D. a shelf registration of securities will occur.

88. Which one of these types of financing commonly provides investors with only sample products? A. Seasoned offering B. Rights offer C. IPO D. Crowdfunding 89. A private placement avoids which one of the following costs? A. Depression in the stock price B. Administration costs C. Registration with the SEC D. Legal costs 90. A private placement of securities involves: A. selling only to the firm's current investors. B. nondisclosure of the issuing firm's name until after the sale. C. the exchange of convertible bonds for equity. D. a nonpublic sale of securities to a limited number of investors. 91. Which one of the following methods may be particularly cost-effective to smaller issuers of securities? A. Seasoned offerings B. Private placement C. General cash offer D. Best efforts underwriting 92. When a new issue goes wrong and the stock price immediately crashes once trading commences, the IPO investors may: A. sue the SEC for recommending the issue. B. convert their shares into bonds. C. sue the company executives who are still shareholders. D. sue the underwriters for overhyping the issue. 93. An investor can earn 20% on underpriced IPOs, but will lose 10% on overpriced IPOs. If he is awarded $2,000 worth of shares in an overpriced IPO, how much of the underpriced issue must he be awarded in order to gain $500 total? A. $1,500 B. $2,500 C. $3,500 D. $10,000 94. An IPO was priced to sell at $23 a share and closed at $22 a share at the end of the first day of trading. The underwriting spread was 7% of the offer price and the legal, accounting and administrative costs were $160,000. What was the total percentage cost of the issue as a percentage of the market value at the end of the first day if 250,000 shares were offered? A. 3.89% B. 5.68% C. 4.21% D. 3.64%

95. Which one of the following is not an advantage of shelf registration? A. The issuing firm can avoid competition from underwriters. B. Securities can be issued with short notice. C. Securities can be issued in small amounts without excessive costs. D. The firm can take advantage of market conditions. 96. Second stage financing: A. involves a substantial increase in leverage. B. immediately follows first-stage financing for every new business. C. may involve issuing additional shares of stock. D. occurs when the company is in danger of bankruptcy. 97. Firms go public primarily to: A. raise additional capital. B. diversify public debt holders' risk. C. maintain ownership control. D. increase their financial leverage. 98. In a firm commitment, the underwriter: A. encounters virtually no risk because the spread is fixed. B. is allowed to sell the shares at any price they choose. C. is protected against being stuck with unsold shares. D. is allowed to sell the shares at a price slightly higher than the price it paid to the company. 99. Those subject to the winner's curse are: A. underwriters. B. uninformed investors. C. firms issuing IPOs. D. venture capitalists. 100. Plasti-tech Inc. has decided to go public and has sold 2 million of its shares to its underwriter for $20 per share. The underwriter then sold them to the public for $22 each. Plasti-tech also encountered $0.5 million in administrative fees. Soon after the issue, the stock price rose to $25. Find Plasti-tech Inc.'s total cost of this issue including any underpricing. A. $4.5 million B. $9.5 million C. $10.5 million D. $14.5 million 101. Economists have found that the announcement of a new issue of common stock: A. results in a decline in the stock price. B. causes the stock price to rise. C. has no effect on the stock price. D. increases the market value of the stock but only temporarily.

102. Currently, M & S Inc. has 2 million shares outstanding selling at $70 a share. A rights issue will be made that allows 1 share to be purchased for every 5 shares currently held by stockholders for $40 each. Which one of the following is true? A. The number of shares outstanding will fall to 1.6 million. B. The firm will raise $13.33 million. C. The stock price will fall to $65. D. The total value of the firm will equal $124 million.

Chapter 15 Test bank - Static Key 1.

Equity capital in young businesses is known as venture capital and it is provided by venture capital firms, wealthy individuals, and investment institutions such as pension funds. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

Venture capitalists generally provide sufficient up-front funding in one lump sum to take a new firm to the point where it can go public. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

In many countries it is common even for large businesses to remain privately owned. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Forms of business organization

Underwriters usually play a triple role-first providing the company with procedural and financial advice, then buying the stock, and finally reselling it to the public. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

Some successful corporations will provide venture capital to new firms with innovative ideas. TRUE AACSB: Communication

Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

A consequence of the Sarbanes-Oxley Act has been a decreased reporting burden on small public companies and a decrease in the number of companies reverting to private ownership. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Financial market regulation

When a public company makes a general cash offer of debt or equity, it essentially follows the same procedure used when it first went public. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

Shelf registration is a procedure that allows firms to file several registration statements for one issue of the security. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

The bookbuilding method used by almost all IPOs in the United States is like an auction, since potential buyers indicate how many shares they are prepared to buy at given prices. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

10.

The SEC requires the sale of a private placement to be limited to a small number of knowledgeable investors. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

11.

The advantage of the bookbuilding method is that it allows underwriters to give preference to those investors whose bids are most helpful in setting the issue price and to offer them a reward in the shape of underpricing. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

12.

When securities are issued under a firm commitment, the underwriter bears the risk of low demand from investors. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

13.

The SEC reviews the registration statement and determines whether or not an investment in the firm is advisable. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Basics of issuing securities

14.

Like a general cash offering, a rights issue is an offer to buy shares made to existing and potential shareholders. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

15.

In a rights offering, the shares are priced at a substantial discount to current market value, which ensures that the shareholders will either exercise the rights themselves or sell them to other investors. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

16.

Shelf registration is used more frequently for equity financing than for debt financing. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

17.

An average-sized firm should expect the underwriting and administrative costs of going public to be around 7% to 8% of the IPO proceeds. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

18.

Issue costs for debt are considerably lower than issue costs for equity securities. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Costs of issuing securities

19.

The evidence indicates that industrial stock prices in the U.S. decrease by approximately 3%, on average, when new equity issues are announced. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Costs of issuing securities

20.

Firms are attracted to the private placement of debt because of the lower average interest rates. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

21.

The contract between the underwriter and the issuing company is known as the new issue prospectus. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Basics of issuing securities

22.

IPOs are generally overpriced in order to raise large amounts of cash. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

23.

The winner's curse theory assumes that the informed investor receives more of the underpriced IPOs. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

24.

Privately placed securities may be difficult to resell. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

25.

A rights issue is one in which a public company offers shares only to existing shareholders in order to raise additional cash. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

26.

Crowdfunding is primarily used as a means for a publicly-traded company to raise additional capital. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Raising capital

27.

A general cash offer is necessary when issuing a private placement. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

28.

Private placement contracts may be custom tailored for firms with special needs or unique opportunities. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

29.

One advantage to private placements is the low cost. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

30.

Private placements tend to be made by smaller firms that usually incur the highest costs when issuing public securities. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

31.

Money that is offered to finance a new business is known as: A. a general cash offer. B. venture capital. C. a private placement. D. a rights issue. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

32.

An investor exercises the right to buy one additional share at $20 for every five shares held. How much should each share be worth after the rights issue if they previously sold for $50 each? A. $35.00 B. $41.67 C. $45.00 D. $46.00 New price = $20 + (5 × $50) / (1 + 5) = $45.00

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

33.

A firm's first offering of stock to the general public is known as: A. first-stage financing. B. an IPO. C. a general cash offer. D. a seasoned offering. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings.

Topic: Initial public offerings

34.

A secondary offering IPO occurs when: A. new shares are sold to provide the company with additional funds. B. the second public issue of equity becomes available. C. the company's founders or venture capitalists market a portion of their shares. D. not all of the shares in a primary IPO were sold. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

35.

The most important function of an underwriter is to: A. assess the firm's capital needs. B. approve the prospectus before distribution to the public. C. provide private placement of the firm's debt. D. buy the securities issue from the firm and resell the securities to the public. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

36.

When underwriters issue securities on a best efforts basis, they: A. sell as much of the stock as possible, but with no guarantee. B. submit a bid for purchase, which the issuer compares to other bids. C. buy the entire issue from the firm. D. guarantee that the issuer will be charged the minimum spread. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

37.

If an underwriter charges the public $40 per share for a new issue after having promised the issuer $38 per share, the spread per share is: A. $1. B. $2. C. $38. D. $40. Spread = $40 − 38 = $2

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

38.

When underwriters are unsure of the demand for a new offering, they: A. reduce their spread. B. undertake the issue on a firm commitment basis. C. undertake the issue on a best efforts basis. D. provide shelf registration for the issue. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

39.

A major purpose of the prospectus is to: A. inform investors of the security's rate of return. B. advise investors of the security's potential risks. C. distribute stock warrants to prospective investors. D. list the security's dividend payment dates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Basics of issuing securities

40.

Studies have shown that, on average, new security issues are: A. subject to flotation costs of approximately 32%. B. overpriced by the amount of the spread. C. underpriced. D. overpriced to reward venture capitalists. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

41.

One reason that underpricing of new issues occurs more frequently than overpricing is that: A. underwriters want to reduce the risk of a firm commitment. B. the demand for a new issue is typically too high. C. underwriters earn low rates of return. D. issuing firms demand that equity be underpriced. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

42.

How much will a firm receive in net funding from a firm commitment underwriting of 250,000 shares priced to the public at $40 if a 10% underwriting spread has been added to the price paid by the underwriter? Additionally, the firm pays $600,000 in legal fees. A. $8,400,000 B. $8,460,025 C. $8,490,909 D. $8,545,455 Net proceeds = [($40 / 1.10) × 250,000] − $600,000 = $8,490,909

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

43.

One reason for an underwriters' syndication is to: A. monitor the actions of the different underwriters. B. reduce the risk of selling a large issue. C. increase the size of the spread. D. avoid the scrutiny of the Securities and Exchange Commission. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

44.

Who bears the bulk of the cost of underpricing an IPO? A. The underwriters B. The investors who purchase IPO shares C. All of the after-IPO shareholders D. The pre-IPO shareholders AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

45.

An IPO was offered to the public at $18 a share with the issuing firm receiving $16.50 of that amount. The issuer incurred $750,000 in legal and administrative costs. At the end of the first trading day, the stock was priced at $22.40 a share. What was the total dollar cost, including both direct and indirect costs, of issuing the securities if 225,000 shares were offered? A. $1,687,500 B. $1,540,000 C. $2,077,500 D. $1,087,500 Total cost = [($22.40 − 16.50) × 225,000] + $750,000 = $2,077,500

46.

The consent of a corporation's stockholders must be received prior to any: A. issue of new securities. B. selection of an underwriter. C. increase in authorized capital. D. private placement of securities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

47.

When securities are issued under a rights issue: A. existing shareholders have the opportunity to expand their holdings. B. shares are offered to the public at a discount. C. the existing shares will increase in price. D. current shareholders have the right to resell their stock to the issuer. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

48.

What would you expect to be the market price of stock after a sold-out rights issue, if each existing shareholder purchases one new share at $60 for each three that he or she currently holds, and the current share price is $100? A. $75 B. $80 C. $85 D. $90 New price = [$60 + (3 × $100)] / (1 + 3) = $90

49.

What was the market price of a share of stock before a rights issue, if one share of new stock could be purchased at $100 for every four shares that were previously owned? The stock price after the successful rights issue was $200. A. $220 B. $225 C. $240 D. $250 $200 = [$100 + (4 × POld)] / (1 + 4); POld = $225

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

50.

Which one of these terms applies to a public company offering new shares to the general public? A. Rights offer B. Initial public offering C. Venture capital offer D. General cash offer AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

51.

Shelf registration was enacted to allow: A. the Department of Justice to prosecute those guilty of insider trading. B. the prospectus to be distributed after the sale of securities begins. C. underwriters to join together in syndication. D. a joint filing for multiple issues of a single security. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

52.

Which one of the following would not be included among the benefits of shelf registration? A. Reduction of lead time for security issuance B. No additional registration necessary for 5 years C. Issuer can take advantage of favorable conditions D. Issuer can search for best underwriting terms AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

53.

The enactment of shelf registration is likely to have increased: A. the cost of issuing new securities. B. the interests of venture capitalists. C. competition among underwriters. D. the underpricing of securities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

54.

If a corporation's management, with its superior knowledge of proposed investments, considers a security issue to be underpriced, it may react by: A. forgoing the security issuance and investment. B. lowering the price of the existing shares to equal the new shares. C. increasing the number of shares to be sold. D. adopting shelf registration, which automatically raises the issue price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic

Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

55.

If a new stock offering were overpriced and could be sold, then the: A. existing shareholders would benefit. B. new investors would gain at the expense of the existing shareholders. C. firm could avoid the underwriting spread. D. firm could avoid the SEC filing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

56.

Issue costs for equity are higher than those for debt for all of the following reasons except: A. equity issues have higher administrative costs. B. underwriting stock is riskier than underwriting bonds. C. equity issues involve significantly more time to sell. D. equity issues have no economies of scale. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

57.

A firm has just issued $250 million of equity which caused its stock price to drop by 3%. Calculate the loss in value of the firm's equity given that its market value of equity was $1 billion before the new issue. A. $7.5 million B. $30.0 million C. $33.3 million D. $37.5 million Loss in value = 0.03 × $1 billion = $30 million

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Costs of issuing securities

58.

Companies offering smaller security issues may prefer to issue them through a: A. private placement because lower rates of return can be offered. B. private placement because it is cheaper than a public issue. C. public issue because it is cheaper than a private placement. D. public issue because more exposure will be achieved. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

59.

Which one of the following statements is incorrect concerning private placements? A. Terms of the financing can be custom-tailored. B. The securities are not made available to the public. C. The securities are often less marketable. D. Only a small amount of corporate debt is financed in this manner. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

60.

Private placement of debt securities occurs more frequently in: A. smaller-sized firms. B. larger-sized firms. C. firms that are using venture capitalists. D. combination with convertible bonds. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

61.

In return for providing funds, venture capitalists generally require: A. collateral equal in value to the funds provided. B. first right to all of the firm's assets. C. an equity position in the firm. D. ownership of the entire firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

62.

Which one of the following is least likely to explain why entrepreneurs contribute their personal funds to start-up projects? Their contribution: A. acts as a signal to venture capitalists. B. repays debt held by the venture capitalist. C. retains a portion of the firm's equity. D. provides incentive to expend effort. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

63.

What is the market value placed on a firm in which an entrepreneur invests $1 million and a venture capitalist invests $3 million in first-stage financing for a 50% interest in the firm? A. $4 million B. $6 million C. $7 million D. $8 million Firm value = $3m / 0.5 = $6m

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

64.

Second-stage financing occurs: A. prior to the initial public offering. B. when company founders sell a portion of their shares. C. after the best efforts of the underwriters. D. when the IPO does not raise sufficient cash. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

65.

One of the primary reasons for disbursing venture capital funds in installments is to: A. avoid tax liability. B. identify and cut losses early. C. increase the importance of the venture capitalist. D. take advantage of the time value of money. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

66.

Roadshows: A. give companies an opportunity to thank investors who have bought the new issue. B. describe the meetings that managers have with investment bankers to select the underwriter to an issue. C. provide underwriters and the company’s management an opportunity to meet potential investors. D. describe the meetings that management has with the SEC to finalize the issue prospectus. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

67.

Stock underwriters are: A. investors seeking low prices. B. regulatory agencies that evaluate equity offerings. C. the firm's founders who guarantee a stock's performance. D. investment banking firms that manage security offerings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

68.

When underwriters offer a firm commitment on a stock issue, they: A. employ their best efforts in selling the stock. B. guarantee the net proceeds to the issuing firm. C. agree to purchase the venture capitalists' shares. D. assure purchasers that the stock will appreciate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

69.

Which one of the following is correct for stock issued under a firm commitment where the underwriter is to receive a spread of 8%? A. The underwriter's profits are guaranteed to be 8%. B. The underwriter must sell at least 92% of the shares. C. The underwriter receives 8% of all shares. D. The underwriter may suffer a loss on the issue. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

70.

An underwriter enters into a firm commitment to sell 1 million shares at $20 each, including a $2 spread. How much does the issuing firm receive if only 500,000 shares are sold? A. $9 million B. $10 million C. $18 million D. $20 million Proceeds to firm = ($20 − 2) × 1m = $18m

71.

An underwriter sells 2 million shares of stock to the public at $40 per share. The issuing firm receives $73 million before non-underwriting costs. A. The underwriter's spread was 2.14%. B. The underwriter’s spread was $40. C. The underwriter’s spread was 8.75%. D. The underwriter’s spread was 9.59%. Spread = $(80 − 73) / 80

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

72.

Blue-sky laws exist in order to: A. protect stock underwriters from fraudulent firms. B. restrict the amount of profit from IPOs. C. control the amount of stock owned by one investor. D. protect investors from deceptive firms. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Financial market regulation

73.

The Securities and Exchange Commission will not permit securities to be sold: A. if they have been overpriced. B. prior to approval of the registration statement. C. unless the issuer guarantees their value. D. until a shelf registration exists. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Financial market regulation

74.

Prospective investors are advised of a stock's potential risks by the: A. underwriter. B. underpricing laws. C. prospectus. D. initial public offering. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Financial market regulation

75.

One way to reduce the risk of marketing a stock is for the underwriter to: A. offer a firm commitment on the issue. B. set the initial stock price below its true value. C. sell the securities in foreign countries. D. offer price rebates on the stock purchases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

76.

The "winner's curse" is a reminder that: A. successful bidders may often overpay for an object. B. underwriters charge excessive fees. C. stocks are much riskier than bonds. D. underpricing an issue is a cost to existing owners. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

77.

The direct expense of a stock issue includes the: A. cost of underpricing the stock. B. underwriting spread and other expenses. C. underwriting spread, other expenses, and cost of underpricing. D. underwriting spread. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

78.

What direct expense is required to market stock if the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each? A. 6.98% B. 7.19% C. 7.75% D. 8.33% Direct expense % = {$1m + [($43 − 40) × 3m]} / ($43 × 3m) = 0.0775, or 7.75%

79.

Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the cost of underpricing? A. $81 million B. $91 million C. $101 million D. $111 million Cost of underpricing = ($70 − 43) × 3m = $81m

80.

Assume the issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. What is the total cost of issuing the securities? A. $81 million B. $91 million C. $101 million D. $111 million Total cost = [($70 − 40) × 3m] + $1m = $91m

81.

Assume an issuer incurs $1 million in other expenses to sell 3 million shares at $40 each to an underwriter and the underwriter sells the shares at $43 each. By the end of the first day's trading, the issuing company's stock price had risen to $70. In percentage terms, how much of the day's closing market value was absorbed by the total costs associated with the issue? A. 13.33% B. 23.33% C. 33.33% D. 43.33% Total cost % = {[($70 − 40) × 3m] + $1m} / ($70 × 3m) = 0.4333, or 43.33%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard

Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

82.

Stock that is sold through a rights issue: A. is offered for cash to the general investing public. B. will not affect the market price of the shares. C. is limited to sales to existing shareholders. D. must be sold on a firm commitment basis. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

83.

What is the primary reason for a reduction in share value after a successful rights issue? The new shares: A. have higher underwriting expenses. B. are offered at attractive prices. C. reduce the firm's return on equity. D. do not include voting rights. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-04 Describe how companies may make private placements of securities. Topic: Rights offerings

84.

A rights issue offers the firm's shareholders one new share of stock at $40 for every three shares of stock they currently own. What should be the stock price after the rights issue if the stock sells for $80 per share before the issue? A. $56.67 B. $60.00 C. $70.00 D. $71.33 New price = [$40 + ($80 × 3)] / (1 + 3) = $70

85.

Shelf registration allows firms to: A. purchase securities for up to 2 years without registration. B. incur only short time delays in selling securities. C. wait for 2 years before paying for securities. D. offer rights issues to the general public. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

86.

Which one of the following statements is generally true concerning the costs of issuing securities? A. Underpricing is rarely a significant cost. B. Legal and other administrative costs generally average less than $1 million. C. Debt is cheaper to issue than equity. D. There are no economies of scale in security issuance. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Costs of issuing securities

87.

Some investors believe that the decision by management to issue equity as opposed to issuing debt is a signal that: A. the stock is currently undervalued. B. the stock is currently overvalued. C. the firm will avoid dilution of stock value. D. a shelf registration of securities will occur. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

88.

Which one of these types of financing commonly provides investors with only sample products? A. Seasoned offering B. Rights offer C. IPO D. Crowdfunding AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Raising capital

89.

A private placement avoids which one of the following costs? A. Depression in the stock price B. Administration costs C. Registration with the SEC D. Legal costs AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

90.

A private placement of securities involves: A. selling only to the firm's current investors. B. nondisclosure of the issuing firm's name until after the sale. C. the exchange of convertible bonds for equity. D. a nonpublic sale of securities to a limited number of investors. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

91.

Which one of the following methods may be particularly cost-effective to smaller issuers of securities? A. Seasoned offerings B. Private placement C. General cash offer D. Best efforts underwriting AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Private placements and leveraged buyouts

92.

When a new issue goes wrong and the stock price immediately crashes once trading commences, the IPO investors may: A. sue the SEC for recommending the issue. B. convert their shares into bonds. C. sue the company executives who are still shareholders. D. sue the underwriters for overhyping the issue. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings.

Topic: Initial public offerings

93.

An investor can earn 20% on underpriced IPOs, but will lose 10% on overpriced IPOs. If he is awarded $2,000 worth of shares in an overpriced IPO, how much of the underpriced issue must he be awarded in order to gain $500 total? A. $1,500 B. $2,500 C. $3,500 D. $10,000 $500 = (0.20 × value of shares) − (0.10 × $2,000); value of shares = $3,500

94.

An IPO was priced to sell at $23 a share and closed at $22 a share at the end of the first day of trading. The underwriting spread was 7% of the offer price and the legal, accounting and administrative costs were $160,000. What was the total percentage cost of the issue as a percentage of the market value at the end of the first day if 250,000 shares were offered? A. 3.89% B. 5.68% C. 4.21% D. 3.64% Total cost % = ({[$22 − $23 × (1 − 0.07)] × 250,000} + $160,000) / ($22 × 250,000) = 0.0568, or 5.68%

95.

Which one of the following is not an advantage of shelf registration? A. The issuing firm can avoid competition from underwriters. B. Securities can be issued with short notice. C. Securities can be issued in small amounts without excessive costs. D. The firm can take advantage of market conditions. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Basics of issuing securities

96.

Second stage financing: A. involves a substantial increase in leverage. B. immediately follows first-stage financing for every new business. C. may involve issuing additional shares of stock. D. occurs when the company is in danger of bankruptcy. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-01 Understand how venture capital works. Topic: Venture Capital

97.

Firms go public primarily to: A. raise additional capital. B. diversify public debt holders' risk. C. maintain ownership control. D. increase their financial leverage. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

98.

In a firm commitment, the underwriter: A. encounters virtually no risk because the spread is fixed. B. is allowed to sell the shares at any price they choose. C. is protected against being stuck with unsold shares. D. is allowed to sell the shares at a price slightly higher than the price it paid to the company. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Underwriting

99.

Those subject to the winner's curse are: A. underwriters. B. uninformed investors. C. firms issuing IPOs. D. venture capitalists. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings. Topic: Initial public offerings

100.

Plasti-tech Inc. has decided to go public and has sold 2 million of its shares to its underwriter for $20 per share. The underwriter then sold them to the public for $22 each. Plasti-tech also encountered $0.5 million in administrative fees. Soon after the issue, the stock price rose to $25. Find Plasti-tech Inc.'s total cost of this issue including any underpricing. A. $4.5 million B. $9.5 million C. $10.5 million D. $14.5 million Total cost = [($25 − 20) × 2m] + $0.5m = $10.5m

101.

Economists have found that the announcement of a new issue of common stock: A. results in a decline in the stock price. B. causes the stock price to rise. C. has no effect on the stock price. D. increases the market value of the stock but only temporarily. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities. Topic: Basics of issuing securities

102.

Currently, M & S Inc. has 2 million shares outstanding selling at $70 a share. A rights issue will be made that allows 1 share to be purchased for every 5 shares currently held by stockholders for $40 each. Which one of the following is true? A. The number of shares outstanding will fall to 1.6 million. B. The firm will raise $13.33 million. C. The stock price will fall to $65. D. The total value of the firm will equal $124 million. Number of shares issued: (2 million / 5) = 400,000 Number of shares outstanding: 2 million + 0.4 million = 2.4 million Firm will raise: $40 × 400,000 = $16 million Total value of firm will increase from $140 million to $156 million Stock price will fall to: ($156 million / 2.4 million) = $65

Chapter 15 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

102

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

102

Learning Objective: 15-01 Understand how venture capital works.

Learning Objective: 15-02 Explain how firms make initial public offerings and the costs of such offerings.

Learning Objective: 15-03 Understand how established firms make subsequent public issues of securities.

Learning Objective: 15-04 Describe how companies may make private placements of securities.

Topic: Basics of issuing securities

Topic: Costs of issuing securities

Topic: Financial market regulation

Topic: Forms of business organization

Topic: Initial public offerings

Topic: Private placements and leveraged buyouts

Topic: Raising capital

Topic: Rights offerings

Topic: Underwriting

Topic: Venture Capital

Chapter 16 Test bank - Static Student: ___________________________________________________________________________

When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. True

When asked about key factors of debt policy, financial managers commonly mention the tax advantage of debt and the importance of maintaining their credit rating. True

False

At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate. True

False

Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their investment, debt is no cheaper than equity. True

False

As long as investors can borrow or lend on their own account on the same terms as the firm, they will not pay extra for firm leverage. True

False

Debt financing affects neither the business risk nor the financial risk of the firm. True

False

Debt finance does not affect the operating risk but it does add financial risk. True

False

Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones. True

False

Debt financing affects neither the operating risk nor the business risk of the firm. True

False

10. Financial leverage describes debt financing's amplification of the effects of changes in operating income on the returns to stockholders. True

False

11. Financial risk is the risk to shareholders that results from debt financing. True

False

12. MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is unaffected by its capital structure. True

False

13. According to MM, debt restructuring will not change the firm’s overall value. True

False

14. According to MM’s proposition II the expected return on equity is equal to the expected return on assets for a levered firm. True

False

15. MM's proposition II states that the expected return on assets increases as the debt-equity ratio increases. True

False

16. MM's proposition II states that the required return on equity increases as the firm's debt-equity ratio increases. True

False

17. The benefit of an interest tax shield is captured by the equity holders. True

False

18. The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them. True

False

19. Even after relaxing the MM assumption of no taxes, restructuring should not affect the value of the firm. True

False

20. Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy. True

False

21. The "trade-off theory" of capital structure suggests that firms have an optimal level of debt. True

False

22. At some debt-equity ratio, the costs of financial distress are expected to overcome the value of the extra interest tax shield for a firm. True

False

23. Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude. True

False

24. The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price. True

False

25. Management's perceived signals to investors form an important component of pecking-order theory. True

False

26. Financial slack means having ready access to cash or debt financing. True

False

27. When additional borrowing causes the probability of financial distress to increase rapidly, the potential costs of distress begin to take a substantial bite out of firm value. True

False

28. A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this will generate $12.50 earnings per share. What will happen to EPS if operating income increases by 33.3% to $2.0 million? A. EPS increases by 25% to $15.63. B. EPS increases by 33.3% to $16.67. C. EPS increases by 40% to $17.50. D. EPS increases by 60% to $20.00. 29. A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $2,500,000 of shares and substitutes an equal amount of additional debt? A. EPS decreases by 33.3% to $10.00. B. EPS decreases by 6.7% to $11.67. C. EPS increases by 20% to $15.00. D. EPS increases by 80% to $22.50. 30. A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt? A. EPS decreases by 33.3% to $10.00. B. EPS stays at $12.50. C. EPS increases by 140% to $30.00. D. EPS increases by 240% to $42.50. 31. Which one of these is not an underlying assumption of MM Proposition I? A. Capital markets function well. B. Investors can borrow or lend on the same terms as firms. C. Taxes remain at their current non-zero levels. D. Securities are fairly priced.

32. Fluctuations in a firm's operating income represent: A. financial leverage. B. the weighted-average cost of capital. C. capital structure. D. business risk. 33. An increase in a firm's financial leverage will: A. increase the variability in earnings per share. B. always reduce the operating risk of the firm. C. increase the value of the firm in an MM world. D. increase the WACC. 34. Financial risk refers to the: A. risk of owning equity securities. B. risk faced by equityholders of firms with debt. C. general business risk of the firm. D. possibility that interest rates will increase. 35. What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes. A. 54.0% B. 60.0% C. 66.7% D. 75.0% 36. Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the expected return on equity if the expected return on assets is 14%? Ignore taxes. A. 16.14% B. 17.86% C. 14.92% D. 15.50% 37. Assume a firm is financed with 60% debt on which it pays interest of 7%. What is the expected return on equity if the expected return on assets is 12%? Ignore taxes. A. 16.14% B. 20.30% C. 19.50% D. 21.67% 38. According to MM Proposition II, as a firm's debt-equity ratio decreases: A. its financial risk increases. B. its operating risk increases. C. the required rate of return on equity increases. D. the required rate of return on equity decreases.

39. An implicit cost of adding debt to the capital structure is that it: A. adds interest expense to the operating statement. B. increases the required return on equity. C. reduces the expected return on assets. D. decreases the firm's beta. 40. When debt is risky: A. bondholders shift some of the firm risk to equityholders. B. equityholders shift some of the firm risk to bondholders. C. the value of the interest tax shield is at its highest. D. there is more overall risk in the firm. 41. What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket? A. $126,000 B. $234,000 C. $360,000 D. $1,050,000 42. A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the tax rate is 35%? A. $245,000 B. $700,000 C. $3,500,000 D. $10,000,000 43. When taxes are considered, the value of a levered firm equals the value of the: A. unlevered firm. B. unlevered firm plus the value of the debt. C. unlevered firm plus the present value of the tax shield. D. unlevered firm plus the value of the debt plus the value of the tax shield. 44. Assume an unlevered firm changes its capital structure to include $1 million in permanent debt at a 7% interest rate. The tax rate is 35%. According to MM I with taxes, the value of the firm will increase by ____ due to this change in its capital structure. A. $35,000 B. $70,000 C. $350,000 D. $700,000 45. In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the: A. firm uses no debt in its capital structure. B. firm uses the maximum amount of debt in its capital structure. C. firm uses a debt-equity ratio of 1.0. D. corporate tax rate approaches 100%.

46. Calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, finances 45% of the market value of its assets with debt, and has a tax rate of 35%. A. 12.83% B. 14.00% C. 14.40% D. 18.20% 47. What is the after-tax cost of debt for a firm in the 35% tax bracket that pays 15% on its debt? A. 5.25% B. 9.75% C. 12.17% D. 20.25% 48. A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What debt-equity ratio produces a WACC of 12%? A. 0.50 B. 0.75 C. 0.67 D. 0.33 49. If the present value of the interest tax shield on debt equals the present value of the costs of financial distress, then the trade-off theory implies that the: A. firm is using the optimal level of debt. B. firm is paying too high an interest rate. C. firm's market value equals its book value. D. firm should increase its use of debt. 50. The present value of the costs of financial distress increases as the debt ratio increases because the: A. expected return on assets increases. B. present value of the interest tax shield is greater. C. equity tax shield is depleted. D. probability of default is greater. 51. When financial disaster is looming, management may borrow to invest in projects having a negative expected NPV because: A. the firm's beta is now negative. B. taxes are no longer a concern. C. the interest tax shield will cover the loan costs. D. the lender bears most of the risk. 52. Firms facing financial distress may pass up positive NPV projects rather than commit new equity because: A. they prefer to finance with debt. B. the benefits are shared with the bondholders. C. no cash is available for dividends. D. there is no interest tax shield associated with equity.

53. The trade-off theory of capital structure suggests that firms: A. add leverage whenever interest rates are low. B. with higher risk should use less debt. C. should use 50% debt and 50% equity. D. should use debt to overcome high par values of stock. 54. The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that: A. minimizes the financial distress costs. B. maximizes the present value of the interest tax shield. C. equates the present values of the incremental interest tax shield and the incremental financial distress costs. D. maximizes the after-tax cash flows that are internally generated. 55. Firms are more likely to restrict borrowing if the: A. return on the financed project is too high. B. firm's asset base is largely intangible. C. firm's asset beta is zero. D. increased debt decreases the firm's WACC. 56. According to the pecking-order theory, managers will often choose to finance with: A. new equity rather than debt, due to bankruptcy costs. B. debt rather than new equity, to avoid a fall in the share price. C. debt rather than retained earnings, to lower the WACC. D. new equity rather than debt, to strengthen EPS. 57. A firm's capital structure is represented by its mix of: A. assets. B. liabilities and equity. C. assets and liabilities. D. assets, liabilities, and equity. 58. Restructuring a firm involves changing the: A. mix of liabilities and equity. B. dividend payout policy. C. managerial personnel. D. types of production equipment utilized. 59. MM Proposition I without taxes states that: A. firms should be all-equity financed to maximize shareholder value. B. shareholders are unaffected by the debt policy of the firm. C. shareholders are indifferent to a firm's value. D. shareholders prefer to invest in all-equity firms.

60. What is the return on equity for a firm with a return on assets of 15%, a return on debt of 10%, and a 0.75 debt-equity ratio? A. 18.75% B. 20.00% C. 23.75% D. 26.25% 61. An all-equity firm has 1 million shares outstanding with a market value of $10 million. It does not pay tax and has an operating income of $1.5 million. If $2 million of 10% debt is issued and the proceeds used to repurchase shares of stock, then the firm's EPS: A. increasesby 20% to $1.80. B. decreasesby 40%to $0.9. C. decreases by 20% to $1.20. D. increasesby 8.3% to $1.63. 62. A firm currently has operating income of $4 million, interest expense of $2 million, and EPS of $2. How low can operating income drop before EPS are reduced by half, to $1? Ignore taxes. A. $3.5 million B. $3.0 million C. $2.5 million D. $2.0 million 63. A firm increases its debt ratio from 50% to 60%. In the absence of taxes, an investor can offset the change in capital structure by: A. selling part of her holding and buying debt. B. borrowing money and investing it in the firm’s equity. C. holding a diversified portfolio. D. switching her investment to convertible bonds. 64. MM proposition I states that a firm's value is unaffected by its: A. required rate of return on equity. B. operating income, in the absence of taxes. C. interest rate paid on debt. D. mixture of debt and equity. 65. A firm's business risk depends upon: A. its use of debt in the capital structure. B. the risk of the firm's assets and operations. C. the types of debt financing utilized. D. the costs of financial distress. 66. The reason that financial leverage increases shareholder risk is that there is: A. more debt which increases the operating risk. B. less equity to absorb the operating risk. C. less business risk to be spread around. D. more financial risk due to reduced business risk.

67. According to MM, leverage may increase expected earnings per share but still leave the share price unchanged because: A. the firm's operating risk decreases. B. the number of shares is decreased. C. the required return on equity increases. D. the firm is less risky. 68. A firm has a WACC of 14%, an expected return on equity of 19%, and a debt-to-asset ratio of 60%. If the firm does not pay tax, what is the interest rate on the debt? A. 6.50% B. 9.90% C. 10.67% D. 11.14% 69. In the absence of taxes, which one of the following would not be expected to change with changes in the firm's capital structure? A. Weighted-average cost of capital B. Expected return on equity C. Expected return on assets D. Expected earnings per share 70. If a firm's expected return on equity equals its expected return on assets, then the: A. expected return on debt exceeds the expected return on assets. B. likelihood of financial distress is high. C. firm has too much debt. D. firm has no debt in its capital structure.

71. MM's proposition II without taxes states that the: A. expected return on equity increases as financial leverage increases. B. expected return on assets decreases as expected return on debt decreases. C. firm's capital structure is irrelevant to the firm's overall value. D. greater the proportion of equity, the higher the expected return on debt. 72. As a firm's debt-equity ratio approaches zero, the firm's expected return on equity approaches: A. the expected return on debt. B. the expected return on assets. C. its maximum. D. zero. 73. With risky debt and MM’s Proposition II, the expected return on assets _____ as the debt-equity ratio _____. A. increases; increases B. decreases; increases C. increases; decreases D. remains constant; increases

74. When a firm pays tax, MM’s Proposition I no longer holds, and the capital structure of the firm can be important due to the: A. lower tax rates on dividends than on debt. B. higher tax rates on retained earnings than on debt. C. interest tax shield. D. higher operating income from lower dividends. 75. The interest tax shield is equal to the: A. difference between the interest expense and income taxes. B. amount of interest paid in a given year. C. product of the interest expense and the tax rate. D. product of the debt principal and the interest rate on debt. 76. Any financial benefit derived from the interest tax shield accrues to the: A. bondholders. B. shareholders. C. bondholders and shareholders equally. D. shareholders and the federal government. 77. The present value of a perpetual tax shield increases as the firm's tax rate _____ and as the amount of the debt_____. A. increases; increases B. increases; decreases C. decreases; decreases D. decreases; increases 78. How much debt is outstanding if the present value of a perpetual tax shield is $300,000, the tax rate is 35% and the interest rate on the debt is 10%? A. $300,000 B. $857,143 C. $3,000,000 D. $3,750,000 79. What is the expected rate of return to equity holders if the firm has a tax rate of 35%, the interest rate on debt is 10%, WACC is 15%, and the debt-asset ratio is 60%? A. 12.50% B. 21.25% C. 22.50% D. 27.75% 80. When corporate taxes and the cost of financial distress are taken into consideration, the market value of a firm is equal to the value of the all-equity firm _____ the PV of the tax shield _____ the costs of financial distress. A. plus; plus B. minus; plus C. plus; minus D. minus; minus

81. According to the trade-off theory, if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs, then the: A. tax shield has been calculated incorrectly. B. firm is too heavily levered. C. firm has reached its optimal debt level. D. firm appears to have a low risk of financial distress. 82. Which ranking of financing from most preferred to least preferred is predicted by the pecking-order theory? A. Debt issue, stock issue, internally generated funds B. Internally generated funds, debt issue, stock issue C. Stock issue, internally generated funds, debt issue D. Internally generated funds, stock issue, debt issue 83. Debt may be the preferred form of external financing for many firms because: A. most firms already have too much equity. B. tax rates on equity are lower. C. debt will not adversely affect the firm's financial ratios. D. equity issuance is considered by investors to be a negative signal. 84. Which one of the following statements is false according to MM's proposition I? A. Firm value is unaffected by the firm's capital structure. B. Proposition I is also called the debt-irrelevance proposition. C. Shareholders should care about the firm's debt policy. D. After restructuring, the firm's value should be the same as it was prior to restructuring. 85. Debt usage will have an effect on: A. business risk. B. financial risk. C. operating risk. D. asset risk. 86. Leverage will _____ shareholders' expected return and ______ their risk. A. increase; decrease B. decrease; increase C. increase; increase D. increase; do nothing to 87. Calculate the firm's expected return on its assets if its expected return on debt is 10%, its expected return on equity is 20%, and the company cost of capital is 14%. A. 14% B. 15% C. 16% D. 17%

88. A firm with a debt-equity ratio of 0.5, a return on assets of 14%, and a return on debt of 8%, will have a return on equity of: A. 15.25%. B. 16.00%. C. 17.00%. D. 17.33%. 89. As the debt-equity ratio decreases when debt is not risk free: A. debtholders require a higher expected return. B. debtholders require a lower expected return. C. the expected return on equity increases. D. the expected return on assets increases. 90. One advantage of debt financing over equity financing is the: A. tax-deductible dividends. B. tax-deductible interest. C. tax-deductible principal repayment. D. tax-free interest income. 91. Those who benefit from the interest tax shield are: A. debtholders. B. equityholders. C. both debtholders and equityholders. D. only the firm's customers. 92. When a corporation issues permanent debt, its value: A. increases by the present value of the tax shield. B. decreases by the present value of the tax shield. C. increases by the annual interest tax shield. D. decreases by the annual interest tax shield. 93. When corporate taxes are considered, how does leverage affect the WACC? A. An increase in leverage will be offset by a decrease in equity financing, thus leaving WACC unchanged. B. Changes in leverage will affect the WACC only if the interest rate on debt changes. C. Increased leverage will increase the WACC. D. Increased leverage will decrease the WACC. 94. According to the trade-off theory, optimal capital structure occurs when: A. additional borrowing results in lower financial distress costs. B. additional borrowing is offset by the interest tax shield. C. the tax savings from additional leverage are offset by the increased costs of distress. D. the present value of the tax shield exceeds the value of the all-equity-financed firm.

95. The possibility of bankruptcy will do all of the following except: A. increase financial distress costs. B. reduce the current market value of the firm. C. reduce the interest rate on debt. D. reduce the possible payoff to stockholders. 96. Costs of financial distress are greater when a firm increases its: A. intangible assets as a percentage of total assets. B. tangible assets as a percentage of total assets. C. net working capital. D. retained earnings. 97. Which one of the following statements is true regarding the trade-off theory? A. Highly profitable firms should have low debt ratios. B. All firms should have the same target debt-equity ratio. C. Riskier firms should have high target debt ratios. D. Less risky firms ought to have a greater amount of debt financing. 98. According to the trade-off theory, capital structure is a trade-off between: A. tangible and intangible asset risk. B. high and low target debt ratios. C. tax savings and financial distress costs. D. tax shields and equity financing. 99. The pecking-order theory suggests that less profitable firms borrow more because: A. equity issues are more expensive. B. leverage is preferred over raising funds internally. C. debt issues are good omens. D. they have insufficient internal funds. 100. Financial slack: A. is associated with high leverage B. allows firms to take advantage of good investment opportunities C. solves any agency costs when managers want to empire-build D. is a term that describes a lazy CFO 101. Which one of these statements corresponds to MM proposition I without taxes? A. Debt interest has no effect on either equity income or firm value. B. Debt interest reduces equity income and increases firm value. C. Debt interest reduces equity income but does not affect firm value. D. The value of a firm increases as its debt-equity ratio increases.

102. Which one of these statements correctly applies to an unlevered firm that pays no taxes? A. The return on equity exceeds the WACC. B. The return on assets equals the return on equity and also equals WACC. C. The return on assets equals the return on equity and exceeds WACC. D. The return on equity equals WACC and exceeds the return on assets. 103. Which one of these is a disadvantage to tax-paying individual investors? A. Receiving interest income rather than dividends B. Receiving capital gains rather than dividends C. Receiving capital gains rather than interest income D. Receiving dividends rather than interest income 104. An increase in a corporation's tax rate will cause: A. an increase in an unlevered firm's return on assets. B. a decrease in a levered firm's WACC. C. an increase in a levered firm's cost of debt. D. a decrease in an unlevered firm's cost of equity. 105. Which of the following pair of firms do you think should be more highly levered: A retailing firm with prime downtown real estate, or a social media company whose major assets are its unique software and client loyalty?

106. Which of the following pair of firms do you think should be more highly levered: A biotech firm which may need a large cash injection if its drug trials are successful, or a company with a well-established market and large cash reserves?

107. Which of the following pair of firms do you think should be more highly levered: A taxpaying company, or a company with large tax loss carry-forwards?

108. Which of the following pair of firms do you think should be more highly levered: A risky company, or a safe company?

Chapter 16 Test bank - Static Key 1.

When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

When asked about key factors of debt policy, financial managers commonly mention the tax advantage of debt and the importance of maintaining their credit rating. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Debt

Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Indenture provisions

Debt finance does not affect the operating risk but it does add financial risk. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

Debt financing affects neither the business risk nor the financial risk of the firm. FALSE AACSB: Communication Accessibility: Keyboard Navigation

Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

As long as investors can borrow or lend on their own account on the same terms as the firm, they will not pay extra for firm leverage. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their investment, debt is no cheaper than equity. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

Debt financing affects neither the operating risk nor the business risk of the firm. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

10.

Financial leverage describes debt financing's amplification of the effects of changes in operating income on the returns to stockholders. TRUE AACSB: Communication

Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Financial and operating leverage

11.

Financial risk is the risk to shareholders that results from debt financing. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

12.

MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is unaffected by its capital structure. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

13.

According to MM, debt restructuring will not change the firm’s overall value. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

14.

According to MM’s proposition II the expected return on equity is equal to the expected return on assets for a levered firm. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

15.

MM's proposition II states that the expected return on assets increases as the debt-equity ratio increases. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

16.

MM's proposition II states that the required return on equity increases as the firm's debt-equity ratio increases. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

17.

The benefit of an interest tax shield is captured by the equity holders. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

18.

The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

19.

Even after relaxing the MM assumption of no taxes, restructuring should not affect the value of the firm. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

20.

Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

21.

The "trade-off theory" of capital structure suggests that firms have an optimal level of debt. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

22.

At some debt-equity ratio, the costs of financial distress are expected to overcome the value of the extra interest tax shield for a firm. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

23.

Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

24.

The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

25.

Management's perceived signals to investors form an important component of pecking-order theory. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

26.

Financial slack means having ready access to cash or debt financing. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

27.

When additional borrowing causes the probability of financial distress to increase rapidly, the potential costs of distress begin to take a substantial bite out of firm value. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

28.

A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this will generate $12.50 earnings per share. What will happen to EPS if operating income increases by 33.3% to $2.0 million? A. EPS increases by 25% to $15.63. B. EPS increases by 33.3% to $16.67. C. EPS increases by 40% to $17.50. D. EPS increases by 60% to $20.00. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Earnings per share

29.

A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $2,500,000 of shares and substitutes an equal amount of additional debt? A. EPS decreases by 33.3% to $10.00. B. EPS decreases by 6.7% to $11.67. C. EPS increases by 20% to $15.00. D. EPS increases by 80% to $22.50. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Earnings per share

30.

A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt? A. EPS decreases by 33.3% to $10.00. B. EPS stays at $12.50. C. EPS increases by 140% to $30.00. D. EPS increases by 240% to $42.50. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Earnings per share

31.

Which one of these is not an underlying assumption of MM Proposition I? A. Capital markets function well. B. Investors can borrow or lend on the same terms as firms. C. Taxes remain at their current non-zero levels. D. Securities are fairly priced. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

32.

Fluctuations in a firm's operating income represent: A. financial leverage. B. the weighted-average cost of capital. C. capital structure. D. business risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

33.

An increase in a firm's financial leverage will: A. increase the variability in earnings per share. B. always reduce the operating risk of the firm. C. increase the value of the firm in an MM world. D. increase the WACC. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Financial and operating leverage

34.

Financial risk refers to the: A. risk of owning equity securities. B. risk faced by equityholders of firms with debt. C. general business risk of the firm. D. possibility that interest rates will increase. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

35.

What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes. A. 54.0% B. 60.0% C. 66.7% D. 75.0% 0.24 = 0.16 + D / E(0.16 − 0.12); D / E = 2 Debt financing % = 2 / (2 + 1) = 0.667, or 66.7%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

36.

Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the expected return on equity if the expected return on assets is 14%? Ignore taxes. A. 16.14% B. 17.86% C. 14.92% D. 15.50% E(R)e = 0.14 + [0.30 / (1 − 0.30)](0.14 − 0.09) = 0.1614, or 16.14%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic

Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

37.

Assume a firm is financed with 60% debt on which it pays interest of 7%. What is the expected return on equity if the expected return on assets is 12%? Ignore taxes. A. 16.14% B. 20.30% C. 19.50% D. 21.67% E(R)e = 0.12 + [0.60 / (1 − 0.60)](0.12 − 0.07) = 0.1950, or 19.50%

38.

According to MM Proposition II, as a firm's debt-equity ratio decreases: A. its financial risk increases. B. its operating risk increases. C. the required rate of return on equity increases. D. the required rate of return on equity decreases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

39.

An implicit cost of adding debt to the capital structure is that it: A. adds interest expense to the operating statement. B. increases the required return on equity. C. reduces the expected return on assets. D. decreases the firm's beta. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

40.

When debt is risky: A. bondholders shift some of the firm risk to equityholders. B. equityholders shift some of the firm risk to bondholders. C. the value of the interest tax shield is at its highest. D. there is more overall risk in the firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

41.

What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket? A. $126,000 B. $234,000 C. $360,000 D. $1,050,000 Annual interest tax shield = 0.12 × $3m × 0.35 = $126,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

42.

A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the tax rate is 35%? A. $245,000 B. $700,000 C. $3,500,000 D. $10,000,000 PV tax shield = (0.07 × $10m × 0.35) / 0.07 = $3.5m

43.

When taxes are considered, the value of a levered firm equals the value of the: A. unlevered firm. B. unlevered firm plus the value of the debt. C. unlevered firm plus the present value of the tax shield. D. unlevered firm plus the value of the debt plus the value of the tax shield. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

44.

Assume an unlevered firm changes its capital structure to include $1 million in permanent debt at a 7% interest rate. The tax rate is 35%. According to MM I with taxes, the value of the firm will increase by ____ due to this change in its capital structure. A. $35,000 B. $70,000 C. $350,000 D. $700,000 PV of interest tax shield = 0.35 × $1m = $350,000

45.

In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the: A. firm uses no debt in its capital structure. B. firm uses the maximum amount of debt in its capital structure. C. firm uses a debt-equity ratio of 1.0. D. corporate tax rate approaches 100%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: M and M Proposition I with taxes

46.

Calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, finances 45% of the market value of its assets with debt, and has a tax rate of 35%. A. 12.83% B. 14.00% C. 14.40% D. 18.20% WACC = (1 − 0.45)(0.18) + 0.45(0.10)(1 − 0.35) = 0.1283, or 12.83%

47.

What is the after-tax cost of debt for a firm in the 35% tax bracket that pays 15% on its debt? A. 5.25% B. 9.75% C. 12.17% D. 20.25% After-tax cost of debt = 0.15 × (1 − 0.35) = 0.0975, or 9.75% = 9.75%

48.

A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What debt-equity ratio produces a WACC of 12%? A. 0.50 B. 0.75 C. 0.67 D. 0.33 0.12 = (0.15)(1 − x) + 0.06x; x = 1 / 3 D/E = (1 / 3) / (1 − 1/3) = 1 / 2, or 0.50

49.

If the present value of the interest tax shield on debt equals the present value of the costs of financial distress, then the tradeoff theory implies that the: A. firm is using the optimal level of debt. B. firm is paying too high an interest rate. C. firm's market value equals its book value. D. firm should increase its use of debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

50.

The present value of the costs of financial distress increases as the debt ratio increases because the: A. expected return on assets increases. B. present value of the interest tax shield is greater. C. equity tax shield is depleted. D. probability of default is greater. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

51.

When financial disaster is looming, management may borrow to invest in projects having a negative expected NPV because: A. the firm's beta is now negative. B. taxes are no longer a concern. C. the interest tax shield will cover the loan costs. D. the lender bears most of the risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

52.

Firms facing financial distress may pass up positive NPV projects rather than commit new equity because: A. they prefer to finance with debt. B. the benefits are shared with the bondholders. C. no cash is available for dividends. D. there is no interest tax shield associated with equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure.

Topic: Financial distress

53.

The trade-off theory of capital structure suggests that firms: A. add leverage whenever interest rates are low. B. with higher risk should use less debt. C. should use 50% debt and 50% equity. D. should use debt to overcome high par values of stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

54.

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that: A. minimizes the financial distress costs. B. maximizes the present value of the interest tax shield. C. equates the present values of the incremental interest tax shield and the incremental financial distress costs. D. maximizes the after-tax cash flows that are internally generated. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

55.

Firms are more likely to restrict borrowing if the: A. return on the financed project is too high. B. firm's asset base is largely intangible. C. firm's asset beta is zero. D. increased debt decreases the firm's WACC. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

56.

According to the pecking-order theory, managers will often choose to finance with: A. new equity rather than debt, due to bankruptcy costs. B. debt rather than new equity, to avoid a fall in the share price. C. debt rather than retained earnings, to lower the WACC. D. new equity rather than debt, to strengthen EPS. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic

Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

57.

A firm's capital structure is represented by its mix of: A. assets. B. liabilities and equity. C. assets and liabilities. D. assets, liabilities, and equity. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital structure

58.

Restructuring a firm involves changing the: A. mix of liabilities and equity. B. dividend payout policy. C. managerial personnel. D. types of production equipment utilized. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: Capital structure

59.

MM Proposition I without taxes states that: A. firms should be all-equity financed to maximize shareholder value. B. shareholders are unaffected by the debt policy of the firm. C. shareholders are indifferent to a firm's value. D. shareholders prefer to invest in all-equity firms. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

60.

What is the return on equity for a firm with a return on assets of 15%, a return on debt of 10%, and a 0.75 debt-equity ratio? A. 18.75% B. 20.00% C. 23.75% D. 26.25% re = 0.15 + 0.75(0.15 − 0.10) = 0.1875, or 18.75%

61.

An all-equity firm has 1 million shares outstanding with a market value of $10 million. It does not pay tax and has an operating income of $1.5 million. If $2 million of 10% debt is issued and the proceeds used to repurchase shares of stock, then the firm's EPS: A. increasesby 20% to $1.80. B. decreasesby 40%to $0.9. C. decreases by 20% to $1.20. D. increasesby 8.3% to $1.63. Initially EPS = $1.5 million / 1 million = $1.5 After restructuring VE = $800,000; number of shares = 800,000; net income = $1.5 million − 0.10 × $2 million = $1.3 million; EPS = $1.3 million / 800,000 = $1.63

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Earnings per share

62.

A firm currently has operating income of $4 million, interest expense of $2 million, and EPS of $2. How low can operating income drop before EPS are reduced by half, to $1? Ignore taxes. A. $3.5 million B. $3.0 million C. $2.5 million D. $2.0 million AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Earnings per share

63.

A firm increases its debt ratio from 50% to 60%. In the absence of taxes, an investor can offset the change in capital structure by: A. selling part of her holding and buying debt. B. borrowing money and investing it in the firm’s equity. C. holding a diversified portfolio. D. switching her investment to convertible bonds. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

64.

MM proposition I states that a firm's value is unaffected by its: A. required rate of return on equity. B. operating income, in the absence of taxes. C. interest rate paid on debt. D. mixture of debt and equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

65.

A firm's business risk depends upon: A. its use of debt in the capital structure. B. the risk of the firm's assets and operations. C. the types of debt financing utilized. D. the costs of financial distress. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

66.

The reason that financial leverage increases shareholder risk is that there is: A. more debt which increases the operating risk. B. less equity to absorb the operating risk. C. less business risk to be spread around. D. more financial risk due to reduced business risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

67.

According to MM, leverage may increase expected earnings per share but still leave the share price unchanged because: A. the firm's operating risk decreases. B. the number of shares is decreased. C. the required return on equity increases. D. the firm is less risky. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

68.

A firm has a WACC of 14%, an expected return on equity of 19%, and a debt-to-asset ratio of 60%. If the firm does not pay tax, what is the interest rate on the debt? A. 6.50% B. 9.90% C. 10.67% D. 11.14% 0.14 = (1 − 0.60)(0.19) + 0.60(Rd); Rd = 0.1067, or 10.67%

69.

In the absence of taxes, which one of the following would not be expected to change with changes in the firm's capital structure? A. Weighted-average cost of capital B. Expected return on equity C. Expected return on assets D. Expected earnings per share AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Capital structure

70.

If a firm's expected return on equity equals its expected return on assets, then the: A. expected return on debt exceeds the expected return on assets. B. likelihood of financial distress is high. C. firm has too much debt. D. firm has no debt in its capital structure.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Capital structure

71.

MM's proposition II without taxes states that the: A. expected return on equity increases as financial leverage increases. B. expected return on assets decreases as expected return on debt decreases. C. firm's capital structure is irrelevant to the firm's overall value. D. greater the proportion of equity, the higher the expected return on debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

72.

As a firm's debt-equity ratio approaches zero, the firm's expected return on equity approaches: A. the expected return on debt. B. the expected return on assets. C. its maximum. D. zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

73.

With risky debt and MM’s Proposition II, the expected return on assets _____ as the debt-equity ratio _____. A. increases; increases B. decreases; increases C. increases; decreases D. remains constant; increases AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium

Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

74.

When a firm pays tax, MM’s Proposition I no longer holds, and the capital structure of the firm can be important due to the: A. lower tax rates on dividends than on debt. B. higher tax rates on retained earnings than on debt. C. interest tax shield. D. higher operating income from lower dividends. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

75.

The interest tax shield is equal to the: A. difference between the interest expense and income taxes. B. amount of interest paid in a given year. C. product of the interest expense and the tax rate. D. product of the debt principal and the interest rate on debt. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

76.

Any financial benefit derived from the interest tax shield accrues to the: A. bondholders. B. shareholders. C. bondholders and shareholders equally. D. shareholders and the federal government. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

77.

The present value of a perpetual tax shield increases as the firm's tax rate _____ and as the amount of the debt_____. A. increases; increases B. increases; decreases C. decreases; decreases D. decreases; increases AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

78.

How much debt is outstanding if the present value of a perpetual tax shield is $300,000, the tax rate is 35% and the interest rate on the debt is 10%? A. $300,000 B. $857,143 C. $3,000,000 D. $3,750,000 $300,000 = D × 0.35; D = $857,143

79.

What is the expected rate of return to equity holders if the firm has a tax rate of 35%, the interest rate on debt is 10%, WACC is 15%, and the debt-asset ratio is 60%? A. 12.50% B. 21.25% C. 22.50% D. 27.75% 0.15 = (1 − 0.60)Re + 0.60(0.10)(1 − 0.35); Re = 0.2775, or 27.75%

80.

When corporate taxes and the cost of financial distress are taken into consideration, the market value of a firm is equal to the value of the all-equity firm _____ the PV of the tax shield _____ the costs of financial distress. A. plus; plus B. minus; plus C. plus; minus D. minus; minus AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

81.

According to the trade-off theory, if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs, then the: A. tax shield has been calculated incorrectly. B. firm is too heavily levered. C. firm has reached its optimal debt level. D. firm appears to have a low risk of financial distress. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

82.

Which ranking of financing from most preferred to least preferred is predicted by the pecking-order theory? A. Debt issue, stock issue, internally generated funds B. Internally generated funds, debt issue, stock issue C. Stock issue, internally generated funds, debt issue D. Internally generated funds, stock issue, debt issue AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

83.

Debt may be the preferred form of external financing for many firms because: A. most firms already have too much equity. B. tax rates on equity are lower. C. debt will not adversely affect the firm's financial ratios. D. equity issuance is considered by investors to be a negative signal. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

84.

Which one of the following statements is false according to MM's proposition I? A. Firm value is unaffected by the firm's capital structure. B. Proposition I is also called the debt-irrelevance proposition. C. Shareholders should care about the firm's debt policy. D. After restructuring, the firm's value should be the same as it was prior to restructuring. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Topic: M and M Proposition I without taxes

85.

Debt usage will have an effect on: A. business risk. B. financial risk. C. operating risk. D. asset risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

86.

Leverage will _____ shareholders' expected return and ______ their risk. A. increase; decrease B. decrease; increase C. increase; increase D. increase; do nothing to AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Business and financial risk

87.

Calculate the firm's expected return on its assets if its expected return on debt is 10%, its expected return on equity is 20%, and the company cost of capital is 14%. A. 14% B. 15% C. 16% D. 17% company cost of capital = expected return on assets = 14%

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Weighted-average cost of capital

88.

A firm with a debt-equity ratio of 0.5, a return on assets of 14%, and a return on debt of 8%, will have a return on equity of: A. 15.25%. B. 16.00%. C. 17.00%. D. 17.33%. re = 0.14 + 0.5(0.14 − 0.08) = 0.17, or 17%

89.

As the debt-equity ratio decreases when debt is not risk free: A. debtholders require a higher expected return. B. debtholders require a lower expected return. C. the expected return on equity increases. D. the expected return on assets increases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition II without taxes

90.

One advantage of debt financing over equity financing is the: A. tax-deductible dividends. B. tax-deductible interest. C. tax-deductible principal repayment. D. tax-free interest income. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Taxes

91.

Those who benefit from the interest tax shield are: A. debtholders. B. equityholders. C. both debtholders and equityholders. D. only the firm's customers. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: M and M Proposition I with taxes

92.

When a corporation issues permanent debt, its value: A. increases by the present value of the tax shield. B. decreases by the present value of the tax shield. C. increases by the annual interest tax shield. D. decreases by the annual interest tax shield. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I with taxes

93.

When corporate taxes are considered, how does leverage affect the WACC? A. An increase in leverage will be offset by a decrease in equity financing, thus leaving WACC unchanged. B. Changes in leverage will affect the WACC only if the interest rate on debt changes. C. Increased leverage will increase the WACC. D. Increased leverage will decrease the WACC. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Weighted-average cost of capital

94.

According to the trade-off theory, optimal capital structure occurs when: A. additional borrowing results in lower financial distress costs. B. additional borrowing is offset by the interest tax shield. C. the tax savings from additional leverage are offset by the increased costs of distress. D. the present value of the tax shield exceeds the value of the all-equity-financed firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

95.

The possibility of bankruptcy will do all of the following except: A. increase financial distress costs. B. reduce the current market value of the firm. C. reduce the interest rate on debt. D. reduce the possible payoff to stockholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

96.

Costs of financial distress are greater when a firm increases its: A. intangible assets as a percentage of total assets. B. tangible assets as a percentage of total assets. C. net working capital. D. retained earnings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Financial distress

97.

Which one of the following statements is true regarding the trade-off theory? A. Highly profitable firms should have low debt ratios. B. All firms should have the same target debt-equity ratio. C. Riskier firms should have high target debt ratios. D. Less risky firms ought to have a greater amount of debt financing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

98.

According to the trade-off theory, capital structure is a trade-off between: A. tangible and intangible asset risk. B. high and low target debt ratios. C. tax savings and financial distress costs. D. tax shields and equity financing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure. Topic: Capital structure

99.

The pecking-order theory suggests that less profitable firms borrow more because: A. equity issues are more expensive. B. leverage is preferred over raising funds internally. C. debt issues are good omens. D. they have insufficient internal funds. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

100.

Financial slack: A. is associated with high leverage B. allows firms to take advantage of good investment opportunities C. solves any agency costs when managers want to empire-build D. is a term that describes a lazy CFO AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack. Topic: Pecking-order theory

101.

Which one of these statements corresponds to MM proposition I without taxes? A. Debt interest has no effect on either equity income or firm value. B. Debt interest reduces equity income and increases firm value. C. Debt interest reduces equity income but does not affect firm value. D. The value of a firm increases as its debt-equity ratio increases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets. Topic: M and M Proposition I without taxes

102.

Which one of these statements correctly applies to an unlevered firm that pays no taxes? A. The return on equity exceeds the WACC. B. The return on assets equals the return on equity and also equals WACC. C. The return on assets equals the return on equity and exceeds WACC. D. The return on equity equals WACC and exceeds the return on assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Weighted-average cost of capital

103.

Which one of these is a disadvantage to tax-paying individual investors? A. Receiving interest income rather than dividends B. Receiving capital gains rather than dividends C. Receiving capital gains rather than interest income D. Receiving dividends rather than interest income AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Taxes

104.

An increase in a corporation's tax rate will cause: A. an increase in an unlevered firm's return on assets. B. a decrease in a levered firm's WACC. C. an increase in a levered firm's cost of debt. D. a decrease in an unlevered firm's cost of equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance. Topic: Taxes

105.

Which of the following pair of firms do you think should be more highly levered: A retailing firm with prime downtown real estate, or a social media company whose major assets are its unique software and client loyalty?

The retailing firm with readily saleable assets.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: manual Learning Objective: 16-05 Specify characteristics that should affect a company’s choice of capital structure. Topic: Financial and operating leverage

106.

Which of the following pair of firms do you think should be more highly levered: A biotech firm which may need a large cash injection if its drug trials are successful, or a company with a well-established market and large cash reserves?

The company with a well-established market and large cash reserves.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: manual

Learning Objective: 16-05 Specify characteristics that should affect a company’s choice of capital structure. Topic: Financial and operating leverage

107.

Which of the following pair of firms do you think should be more highly levered: A taxpaying company, or a company with large tax loss carry-forwards?

The taxpaying company with income to shield.

108.

Which of the following pair of firms do you think should be more highly levered: A risky company, or a safe company?

The safe company.

Chapter 16 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

108

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

104

Gradable: manual

Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets.

Learning Objective: 16-02 Calculate interest tax shields and explain why the U.S. tax system encourages debt finance.

Learning Objective: 16-03 Describe the costs of financial distress and explain the trade-off theory of capital structure.

Learning Objective: 16-04 Explain the benefits (and sometimes costs) of financial slack.

Learning Objective: 16-05 Specify characteristics that should affect a company’s choice of capital structure.

Topic: Business and financial risk

Topic: Capital structure

Topic: Cost of debt

Topic: Debt

Topic: Earnings per share

Topic: Financial and operating leverage

Topic: Financial distress

Topic: Indenture provisions

Topic: M and M Proposition I with taxes

Topic: M and M Proposition I without taxes

Topic: M and M Proposition II without taxes

Topic: Pecking-order theory

Topic: Taxes

Topic: Weighted-average cost of capital

Chapter 17 Test bank - Static Student: ___________________________________________________________________________

Stocks that are purchased on the record date are not entitled to the dividend. True

Anyone holding a stock before its ex-dividend date is entitled to the dividend. True

False

Dividends are paid to all shareholders who are recorded in its books on the payment date. True

False

Many companies offer their shareholders an automatic dividend reinvestment plan. This means that the shareholders automatically receive the dividend on the payment date. True

False

In a three-for-two stock split, each investor would receive one additional share for each two shares already held. True

False

Over the past 30 years stock repurchases have become an increasingly popular way of paying out cash. True

False

In recent years more than half of U.S. corporations did not pay a dividend nor did they repurchase shares. True

False

Companies can pay out cash to their shareholders in two ways. They can pay a dividend or they can buy back some of their outstanding shares. True

False

Dividends are paid to all shareholders who are recorded in its books on the record date. True

False

10. A two-for-one stock split is like a 200% stock dividend True

False

11. Investors often interpret a stock split announcement as a signal of management's confidence in the future. True

False

12. A stock split will affect the stock's price, while a stock dividend will not. True

False

13. Stock repurchases are more volatile than dividends. True

False

14. The share price declines when a stock repurchase occurs. True

False

15. Dividends are likely to shift up and down as earnings fluctuate so that managers can maintain a stable payout ratio. True

False

16. Corporate dividends are less volatile than corporate earnings. True

False

17. MM's dividend irrelevance proposition assumes an efficient market with no taxes or issue costs. True

False

18. According to the MM dividend irrelevance proposition, since investors do not need dividends to convert their shares to cash, they will not pay higher prices for firms with higher dividend payouts. True

False

19. The most common way that companies buy back their stock is to buy it in the market just like any other investor. True

False

20. The information content of dividends says that dividend increases send good news about cash flow and earnings, while dividend cuts send bad news. True

False

21. The longer an investor waits to take capital gains, the lower is the present value of the tax liability. True

False

22. Firms can increase their stock price by increasing their dividends to a level that appeals to the clientele group that prefers highdividend stocks. True

False

23. A dividend will be paid to shareholders on Friday, May 9. To receive this dividend you must purchase the stock no later than: A. The payment date. B. The with-dividend date. C. The record date. D. The ex-dividend date.

24. You currently own 200 shares of stock valued at $6 per share. If the firm declares a 1-for-4 reverse stock dividend you will own ____ shares valued at ___ per share. A. 800; $6 B. 800; $1.50 C. 50; $6 D. 50; $24 25. A stock goes ex-dividend: A. two business days prior to the record date. B. two business days after the declaration date. C. three business days after the record date. D. three business days prior to the payment date. 26. What would you expect to happen to the price of a share of stock on the day it goes ex-dividend if you ignore taxes? The price should: A. increase by the amount of the dividend. B. decrease by the amount of the dividend. C. decrease by one-half the amount of the dividend. D. remain constant. 27. Which one of these is the most common method of share repurchase? A. Tender offer B. Auction repurchase C. Direct negotiation D. Open-market repurchase 28. Boards of directors may be legally restricted in their declaration of dividends if: A. cash must be borrowed for the dividend payment. B. dividends have increased substantially over a short period of time. C. the dividend would create a situation of insolvency. D. the stock is selling at a low relative price. 29. ABC Corp. stock is selling for $30 per share when a 10% stock dividend is declared. If you own 100 shares of ABC Corp. then you will receive: A. shares valued at $3 each. B. $3 times 100 shares = $300 cash. C. $300 plus 10 shares of ABC Corp. D. 10 shares of ABC Corp. 30. Which statement is correct? A. Stock that has been repurchased must be put in the firm’s Treasury and cannot be resold. B. Most repurchases are mandatory. Investors are obliged to sell part of their holding back to the company. C. Corporations are much more willing to cut repurchases than dividends. D. Companies like to smooth repurchases.

31. Which of the following is not a way to repurchase stock? A. open-market repurchase B. repurchase a block of shares from a major shareholder C. make a rights issue D. tender offer 32. An investor owns 5,000 shares, which is 1% of a corporation's outstanding stock before a stock repurchase. The investor did not sell any of his stock during the 25,000 share repurchase. Which one of the following statements is correct? A. The investor still owns 1% of the corporation. B. The stock's price is likely to drop by 5%. C. The investor owns more than 1% of the corporation. D. The investor now has 5,250 shares. 33. Which one of these statements is correct? A. Dividends tend to fluctuate in direct relation to changes in annual earnings. B. Managers are less concerned with the change in the dividend than with the actual amount of the dividend. C. Managers tend to avoid smooth dividends as they don't signal the firm's most recent successes. D. Managers tend to only increase dividends when they believe the increased amount can be sustained. 34. Stock repurchases may be interpreted by investors as a signal that: A. future repurchases will be forthcoming. B. the firm's shares are underpriced. C. the firm has an increasing number of positive-NPV opportunities. D. stock repurchases will gradually replace the stock dividends. 35. A firm has current assets of $1.2 million, fixed assets of $3.6 million, and debt of $2.2 million. There are 250,000 shares of stock outstanding. What will be the book value of equity if the firm repurchases 10% of its outstanding shares for $10.40 a share? A. $2,552,000 B. $2,600,000 C. $2,340,000 D. $2,574,000 36. A policy of dividend "smoothing" refers to: A. maintaining a constant dividend payout ratio. B. keeping the regular dividend at the same level indefinitely. C. maintaining a steady progression of dividend increases over time. D. alternating cash dividends with stock dividends. 37. How are investors most apt to interpret a reduction in a firm's regular dividend payment? A. Earnings are expected to decline. B. New investments are expected to increase. C. Stock repurchases are expected to increase. D. Share price is expected to increase.

38. What is the new share price for a corporation with a current share price of $4 that employs a 2-for-9 reverse split? A. $8 B. $16 C. $36 D. $18 39. If investors are expecting a dividend cut, then the announcement of the decreased dividend payment will: A. cause the stock price to decline by more than the dividend amount. B. not affect the stock price as long as the announcement was in line with expectations. C. cause the stock price to increase if the cut was greater than anticipated. D. signal that the next dividend will be cut even further. 40. MM's proposition of dividend irrelevance depends upon: A. firms maintaining a constant dividend payout. B. dividends being taxed the same as capital gains. C. the existence of a dividend clientele. D. the efficiency of capital markets. 41. A firm has $250,000 to spend on either a one-time special dividend or on a share repurchase program. If the share repurchase is selected, then the firm's: A. value will decrease just as if the dividend option had been selected. B. balance sheet will be unaffected and the share price will remain constant. C. equity balance will be reduced by less than it would have been under the dividend option. D. shareholders will receive less value than under the dividend option. 42. Based on the dividend growth model, a lower current payout will not affect the stock price, provided that the: A. required return on the stock is proportionately increased. B. growth rate in dividends remains constant. C. reduction is offset by an increase in the growth rate. D. growth rate is decreased by the percent decrease in the dividend. 43. Why are dividend changes rather than the absolute level of dividends perceived to be more important to managers and shareholders? A. Managers change dividends only under threatening conditions. B. Dividend changes are thought to signal future expectations. C. MM's argument states that the absolute level of dividends is irrelevant. D. Dividend changes determine whether borrowing must occur. 44. Which one of the following signals is most likely to elicit a decrease in share price? A. A repurchase of 5% of the firm's stock B. An increase in the regular quarterly dividend C. A decrease in the regular quarterly dividend D. Borrowing funds in order to pay a cash dividend

45. An increase in share price following an increase in dividends is logical if the: A. firm borrows to obtain cash for the dividend. B. increased dividend signals higher future earnings. C. dividend is believed to be temporary. D. clientele effect is not important. 46. Which one of these parties is most likely to prefer a stock with a high-dividend payout policy? A. Financial institutions B. Retired individuals C. Growth-seeking investors D. Endowment funds 47. An investor buys a stock today for $26, receives a dividend of $2 at the end of the year and then sells the stock for $30. If the dividend is taxed at 40% and the capital gain at 20%, what is his return after tax? A. 23.08% B. 16.92% C. 9.23% D. 31.15% 48. What is the difference in the one-year after-tax returns on the following two stocks, assuming a 40% tax rate on dividends and a 20% tax rate on capital gains? Stock A is purchased for $50, pays a $2.5 dividend at the end of the year, and is then sold for $56; stock B is purchased for $60, pays no dividend, but is sold after one year for $70. A. Stock A's after-tax return is higher by 1.27%. B. Stock B's after-tax return is higher by 0.73%. C. Stock A's after-tax return is higher by 0.27%. D. Stock B's after-tax return is higher by 0.58%. 49. A company is more likely to repurchase stock rather than pay out dividends when the firm: A. wants to distribute excess cash by making a regular commitment to its investors. B. wants to conserve current cash. C. wants to avoid a commitment for future distributions. D. foresees excess cash as a common long-term occurrence. 50. Capital gains may be preferred by investors over dividends even if dividends and capital gains are taxed at the same rate because: A. taxes on dividends are withheld immediately. B. taxes on capital gains are paid annually. C. taxes on capital gains can be deferred. D. after-tax dividends are less certain than capital gains.

51. Compare the after-tax returns for a corporation that invests in preferred stock with a 12% dividend yield versus a common stock with no dividend but a 16% capital gain. The corporation's tax rate is 35%. The: A. common stock returns 2.60% more than the preferred. B. preferred stock returns 0.34% more than the common. C. common stock returns 2.32% more than the preferred. D. returns are equal on an after-tax basis. 52. Why may a large increase in earnings not translate into a large increase in dividends? A. The earnings will be taxed. B. Some investors may prefer capital gains. C. Managers wish to assess the earning's persistence. D. The earnings may already be a part of retained earnings. 53. You purchased a stock today. What should you expect if the stock goes ex-dividend tomorrow? A. A dividend will be declared tomorrow. B. A dividend will be paid tomorrow. C. The stock price should decline tomorrow. D. The stock price has already adjusted for the next dividend payment. 54. With respect to the dividend-payment process, the price of a share of stock can logically be expected to drop on: A. the payment date. B. the date of record. C. the ex-dividend date. D. the declaration date. 55. Automatic dividend reinvestment plans allow firms to: A. pay dividends on a more frequent schedule. B. reduce their cash outflow to shareholders. C. transform regular dividends into stock dividends. D. avoid the ex-dividend date reduction in stock price. 56. Evenglade Corp has 1,000 shares outstanding priced at $10 a share. The company is unsure whether to pay out $1 a share as a dividend or to use the money to repurchase stock. If it pays a dividend, what happens to the stock price? If it repurchases, how many shares will remain and at what price? A. After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price falls to $9. B. After the dividend payment stock price falls to $9. If Evenglade repurchases, 800 shares remain and the share price stays at $10. C. After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price stays at $10. D. After the dividend payment stock price stays at $10. If Evenglade repurchases, 900 shares remain and the share price rises to $11.11.

57. Firm X will a dividend of $10 next year and its stock is expected to sell at $100 after the payment. Firm Y pays no dividend but its stock is expected to sell at $110. Dividends are taxed at 30% and capital gains are untaxed. If both stocks offer an after-tax return of 8%, what is the price of the two stocks? A. Price of X = $101.85; price of Y = $101.85 B. Price of X = $99.07; price of Y = $101.85 C. Price of X = $100; price of Y = $101.85 D. Price of X = $99.07; price of Y = $100 58. What effect does a stock dividend have on the book and market values of the firm? A. Both the book and market values increase B. Book value increases; market value decreases C. Book value decreases; market value increases D. Both the book and market values remain constant 59. An investor owns 300 shares of stock currently selling for $70 per share. After a 3-for-2 stock split, the investor will have: A. 200 shares selling for $93.10 each. B. 200 shares selling for $105.00 each. C. 450 shares selling for $46.67 each. D. 450 shares selling for $93.10 each. 60. When a corporation engages in a 10% stock repurchase, it: A. offers shareholders 110 shares for every 100 they currently own. B. purchases for cash 10% of the outstanding shares. C. sells treasury stock at a 10% discount to investors. D. issues 10% more stock but holds the shares as treasury shares. 61. A share repurchase is said to be equivalent to the payment of a cash dividend because each strategy: A. causes share price to decline. B. causes share price to remain constant. C. creates the same tax liability for the investor. D. reduces the assets of the firm by the same amount. 62. Assuming no market imperfections, which one of the following will not be affected by a repurchase of shares? A. Assets of the firm B. Equity of the firm C. Shares outstanding D. Price per share 63. Assuming no market imperfections, which one of the following would not be expected to have an effect on share price? A. Dividend declaration and payment B. Stock repurchase C. Stock dividend D. Stock split

64. Which one of the following is correct for a firm with $400,000 in net earnings, 50,000 shares, and a 30% payout ratio? A. Retained earnings will increase by $120,000. B. Each share will receive a $1.20 dividend. C. $120,000 will be spent on new investments. D. The dividend per share will be $2.40. 65. A firm is said to be "smoothing" dividends if dividends: A. are paid through an automatic dividend reinvestment plan. B. change more gradually than changes in earnings. C. increase by the same dollar amount each year. D. are paid only in even dollar amounts. 66. Managers have been characterized as reluctant to increase dividends if: A. dividends were increased in the preceding year. B. earnings have permanently increased. C. the dividend increase cannot be sustained. D. the dividend payout ratio exceeds 20%. 67. Dividend changes are typically viewed by investors as signals of future changes in: A. investment. B. the firm's WACC. C. earnings. D. the clientele effect. 68. An unlevered firm expects to generate and payout free cash flows of $120,000 annually in the form of dividends and share repurchases starting next year. The discount rate is 13% and there are 125,000 shares outstanding. What is the current value per share? A. $7.38 B. $0.96 C. $1.08 D. $6.87 69. B Corp has announced four dates (payment date, ex-dividend date, announcement date and record date) associated with its forthcoming dividend. The dates are August 1, October 1, August 30 and August 28. Which one of these dates is the record date and which is the ex-dividend date? A. Record date = October 1, ex-dividend date = August 30. B. Record date = August 28, ex-dividend date = August 30. C. Record date = August 1, ex-dividend date = August 28. D. Record date = August 30, ex-dividend date = August 28. 70. MM's proposition concerning dividends contends that shareholders will: A. offer higher prices for higher dividend payouts. B. not offer higher prices for higher dividend payouts. C. offer higher prices for lower dividend payouts. D. purchase only stocks that have high dividend payouts.

71. MM's assertion that dividend policy will not affect the value of the firm requires that dividend policy does not: A. alter the retained earnings of the firm. B. affect investment and borrowing policies. C. allow the payout ratio to change. D. alter the number of outstanding shares. 72. The manager of XYZ Corp. feels that a dividend increase will increase the stock price because many investors value stock with a dividend-discount model. Why might MM disagree with this assertion? A. The increased dividend makes the firm much riskier. B. If investment policy is to remain unchanged, the company will need to replace the cash with a stock issue. C. Investors prefer capital gains over dividends. D. Dividend increases will increase the book value but not the market value of the firm. 73. Market imperfections may make the choice between dividends and repurchases relevant. Which of the following is not one of these imperfections? A. Institutional restrictions on stock holdings B. Differences in dividend-payout ratios C. Taxes on dividends and capital gains D. Differences among investors in marginal tax rates 74. A stock is currently priced at $65 per share and will pay a $4 dividend in one year. What must the stock sell for in one year to meet investors' expectations of a 15% after-tax return if dividends are taxed at 28% and there are no capital gains taxes? A. $70.75 B. $71.87 C. $73.63 D. $76.00 75. Corporations may have a legitimate preference for dividends over capital gains because: A. capital gains have a 50% tax rate. B. dividends received by corporations are not taxable. C. 30% of dividends received by corporations are exempt from taxation. D. 70% of dividends received by corporations are exempt from taxation. 76. Stock A has a dividend yield of 8% but no capital gain. Stock B offers a capital gain but no dividend. If a corporate investor in the 35% tax bracket earns the same after-tax return from the two stocks, what capital gain does B offer? A. 8.00% B. 9.29% C. 11.02% D. 12.31% 77. The date on which actual dividend checks are mailed to shareholders is the: A. declaration date. B. payment date. C. ex-dividend date. D. record date.

78. An investor who owns stock on the company's __________ date will receive the dividends declared. A. ex-dividend B. record C. payment D. declaration 79. Which one of the following is the order in which key dividend dates occur? A. Declaration, record, ex-dividend, payment B. Declaration, ex-dividend, record, payment C. Record, declaration, payment, ex-dividend D. Ex-dividend, record, declaration, payment 80. A corporation that has an automatic reinvestment plan: A. forces shareholders to automatically reinvest dividends in the company. B. never physically pays out declared dividends. C. gives shareholders the option of purchasing either debt or equity shares. D. gives shareholders the option to re-invest the dividend in additional shares. 81. The primary purpose of laws prohibiting a firm from paying dividends that include its legal capital is to: A. reduce investors' tax liability. B. ensure that the balance sheet balances. C. prevent managers from paying out a substantial proportion of the firm's assets. D. prevent managers from paying large dividends. 82. Kappa Corp has just raised its dividend from $2.50 to $5 per share. (It plans to reduce its repurchases by a similar amount.) Caterina Chekov, who owns 100 shares of Kappa does not need the extra cash. What can she do to offset the change in dividend policy? A. reinvest the extra dividend in Kappa stock. B. sell $250 of Kappa stock each year. C. borrow $250 and invest it in Kappa stock. D. Nothing. She should sell out and invest elsewhere. 83. Kappa Corp and Lambda Corp are identical except that Kappa pays a dividend of $5 per share, while Lambda pays no dividend and uses the cash to repurchase stock. Peter Berngarten owns 100 shares of Kappa. How could he raise the same amount of spending money if instead he owned 100 shares of Lambda? A. He could sell $500 worth of shares of Lambda each year. B. He couldn’t; he could not be sure of the price at which he could sell Lambda stock. C. He could sell 5 shares of Lambda each year. D. He could borrow against his holding of Lambda stock.

84. Zeta Corp has 1,000 shares outstanding. Its stock is priced at $100 a share and shareholders expect Zeta to pay dividends of $10 a year in perpetuity. Now the president suddenly announces that it will keep the total payout the same but will pay only a quarter of the total amount as dividends and use the remaining cash to buy back stock. What will happen to the share price now and how much will the share price grow each year? A. The value of the shares will be unchanged by the announcement and will not grow.0%. B. The share price will be unchanged by the announcement. Subsequently the share price will grow by 7.5% each year. C. The share price will halve and then grow by 7.5% a year. D. The share price will be unchanged by the announcement and will decline by 10% a year. 85. Which one of the following statements regarding stock dividends and stock splits is true? A. A two-for-one stock split is equivalent to a 50% stock dividend. B. A three-for-one stock split is equivalent to a 66% stock dividend. C. A three-for-two stock split is equivalent to a 100% stock dividend. D. A three-for-two stock split is equivalent to a 50% stock dividend. 86. Stock repurchases: A. decrease the number of authorized shares. B. affect every shareholder. C. are optional to the shareholders. D. always increase shareholder value. 87. Research has shown all of the following to be true of the way corporations determine dividends except: A. Firms have short-run target payout ratios. B. Firms have long-run target payout ratios. C. The focus is more on dividend changes rather than absolute dividends. D. Managers try to avoid dividend changes that may need to be reversed. 88. Which of the following statements is false? A. Most mature companies pay dividends. B. Many companies pay dividends and repurchase stock. C. Repurchases fluctuate more than dividends. D. Stock repurchases have become less common over the past 30 years. 89. Given a set investment policy and capital structure, then payout policy is a trade-off between ___________ and ___________. A. retained earnings; borrowing B. capital budgeting; cash dividends C. cash dividends; stock issues and repurchases D. stock splits; stock dividends 90. Which statement is correct? A. the dividend discount model is no longer applicable when there are stock repurchases. B. when valuing free cash flow per share it is important to include both dividends per share and the cash received from repurchases. C. shareholders like dividends because it is the only way that they can get their hands on cash. D. if capital investment and capital structure are held constant, smaller dividends mean larger repurchases.

91. With respect to the proposition that dividend policy does not matter, in order to raise an additional $5,600 in cash by issuing stock, the stock sold must be worth: A. more than $5,600. B. $2,800. C. $5,600. D. less than $5,600. 92. The Beta Corporation has 1,000 shares outstanding and a market value of $90,000. What will be the market value per share after the firm distributes a $5 per share dividend? Ignore taxes and market imperfections. A. $90 B. $85 C. $80 D. $87.50 93. Q Corp has decided to pay out an extra $1 million to shareholder, while keeping investment policy and capital structure constant. Which statement is false? A. Q Corp must issue $1 million of stock to replace the lost cash. B. the new shareholders will demand to receive shares worth $1 million. C. the old shareholders will have reduced their stake in the firm by $1 million. D. the reduced stake that old shareholders have in the firm will more than offset the benefit of the higher dividend. 94. A dividend increase may be used as __________ of a firm's __________. A. an indicator; high capital gains B. an indicator; tax liability C. a signal; poor prospects D. a signal; good prospects 95. Which party receives the greatest tax benefit from receiving dividends rather than capital gains? A. Individual investors B. Corporations C. Financial institutions D. Foundations 96. Which of the following statements is correct? A. Investors rightly prefer repurchases because the reduced number of shares increases earnings per share. B. Companies with large repurchase programs usually finance them by a cut in dividends. C. Companies pay out as dividends whatever is left over after making needed capital investments. D. A stock repurchase does not increase stock price but it does avoid the fall in price that would occur on the ex-dividend date. 97. In MM's analysis, which one of these is not fixed? A. Debt payments B. Investment policy C. Capital structure D. Payout decisions

98. Three of the following considerations may suggest that the firm should start paying out cash to its shareholders. Which one is not a relevant consideration? A. Is the company generating positive free cash flow? B. The company is earning a high profit margin? C. Does the company have sufficient cash for emergencies and unexpected investment opportunities? D. Is the debt ratio prudent? 99. Which one of these firms would you most expect to have the highest payout percentage? A. New technology firm B. Mature firm in a declining industry C. Mature firm with limited growth opportunities D. Rapidly expanding firm in a growth industry 100. Under which conditions are shareholders most likely to be concerned about agency conflicts? A. Growth firm with financing needs that use most of the firm's available cash flows B. Young firm with negative free cash flows C. Large free cash flows generated by a mature firm D. Mature firm with a low retention ratio and frequent stock repurchases

Chapter 17 Test bank - Static Key 1.

Stocks that are purchased on the record date are not entitled to the dividend. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

Anyone holding a stock before its ex-dividend date is entitled to the dividend. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

Companies can pay out cash to their shareholders in two ways. They can pay a dividend or they can buy back some of their outstanding shares. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

In recent years more than half of U.S. corporations did not pay a dividend nor did they repurchase shares. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Payout policy observations

Over the past 30 years stock repurchases have become an increasingly popular way of paying out cash. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember

Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

In a three-for-two stock split, each investor would receive one additional share for each two shares already held. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock splits

Many companies offer their shareholders an automatic dividend reinvestment plan. This means that the shareholders automatically receive the dividend on the payment date. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividend reinvestment plans

Dividends are paid to all shareholders who are recorded in its books on the payment date. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

Dividends are paid to all shareholders who are recorded in its books on the record date. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

10.

A two-for-one stock split is like a 200% stock dividend TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy

Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock splits

11.

Investors often interpret a stock split announcement as a signal of management's confidence in the future. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock splits

12.

A stock split will affect the stock's price, while a stock dividend will not. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividend policy

13.

Stock repurchases are more volatile than dividends. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

14.

The share price declines when a stock repurchase occurs. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

15.

Dividends are likely to shift up and down as earnings fluctuate so that managers can maintain a stable payout ratio. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividend policy observations

16.

Corporate dividends are less volatile than corporate earnings. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividend policy observations

17.

MM's dividend irrelevance proposition assumes an efficient market with no taxes or issue costs. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

18.

According to the MM dividend irrelevance proposition, since investors do not need dividends to convert their shares to cash, they will not pay higher prices for firms with higher dividend payouts. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

19.

The most common way that companies buy back their stock is to buy it in the market just like any other investor. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

20.

The information content of dividends says that dividend increases send good news about cash flow and earnings, while dividend cuts send bad news. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Payout policy considerations

21.

The longer an investor waits to take capital gains, the lower is the present value of the tax liability. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-04 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy. Topic: Tax effects on dividends and payouts

22.

Firms can increase their stock price by increasing their dividends to a level that appeals to the clientele group that prefers high-dividend stocks. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy

23.

A dividend will be paid to shareholders on Friday, May 9. To receive this dividend you must purchase the stock no later than: A. The payment date. B. The with-dividend date. C. The record date. D. The ex-dividend date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

24.

You currently own 200 shares of stock valued at $6 per share. If the firm declares a 1-for-4 reverse stock dividend you will own ____ shares valued at ___ per share. A. 800; $6 B. 800; $1.50 C. 50; $6 D. 50; $24 Number of shares = 200 / 4 = 50; Price = $6 × 4 = $24

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Stock splits

25.

A stock goes ex-dividend: A. two business days prior to the record date. B. two business days after the declaration date. C. three business days after the record date. D. three business days prior to the payment date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

26.

What would you expect to happen to the price of a share of stock on the day it goes ex-dividend if you ignore taxes? The price should: A. increase by the amount of the dividend. B. decrease by the amount of the dividend. C. decrease by one-half the amount of the dividend. D. remain constant. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Cash dividends

27.

Which one of these is the most common method of share repurchase? A. Tender offer B. Auction repurchase C. Direct negotiation D. Open-market repurchase AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

28.

Boards of directors may be legally restricted in their declaration of dividends if: A. cash must be borrowed for the dividend payment. B. dividends have increased substantially over a short period of time. C. the dividend would create a situation of insolvency. D. the stock is selling at a low relative price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Payout policy considerations

29.

ABC Corp. stock is selling for $30 per share when a 10% stock dividend is declared. If you own 100 shares of ABC Corp. then you will receive: A. shares valued at $3 each. B. $3 times 100 shares = $300 cash. C. $300 plus 10 shares of ABC Corp. D. 10 shares of ABC Corp. Shares received = 0.10 × 100 = 10 shares

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock dividends

30.

Which statement is correct? A. Stock that has been repurchased must be put in the firm’s Treasury and cannot be resold. B. Most repurchases are mandatory. Investors are obliged to sell part of their holding back to the company. C. Corporations are much more willing to cut repurchases than dividends. D. Companies like to smooth repurchases. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

31.

Which of the following is not a way to repurchase stock? A. open-market repurchase B. repurchase a block of shares from a major shareholder C. make a rights issue D. tender offer AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

32.

An investor owns 5,000 shares, which is 1% of a corporation's outstanding stock before a stock repurchase. The investor did not sell any of his stock during the 25,000 share repurchase. Which one of the following statements is correct? A. The investor still owns 1% of the corporation. B. The stock's price is likely to drop by 5%. C. The investor owns more than 1% of the corporation. D. The investor now has 5,250 shares. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

33.

Which one of these statements is correct? A. Dividends tend to fluctuate in direct relation to changes in annual earnings. B. Managers are less concerned with the change in the dividend than with the actual amount of the dividend. C. Managers tend to avoid smooth dividends as they don't signal the firm's most recent successes. D. Managers tend to only increase dividends when they believe the increased amount can be sustained. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

34.

Stock repurchases may be interpreted by investors as a signal that: A. future repurchases will be forthcoming. B. the firm's shares are underpriced. C. the firm has an increasing number of positive-NPV opportunities. D. stock repurchases will gradually replace the stock dividends. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

35.

A firm has current assets of $1.2 million, fixed assets of $3.6 million, and debt of $2.2 million. There are 250,000 shares of stock outstanding. What will be the book value of equity if the firm repurchases 10% of its outstanding shares for $10.40 a share? A. $2,552,000 B. $2,600,000 C. $2,340,000 D. $2,574,000 Equity = $1.2m + 3.6m − 2.2m − (0.10 × 250,000 × $10.40) = $2,340,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

36.

A policy of dividend "smoothing" refers to: A. maintaining a constant dividend payout ratio. B. keeping the regular dividend at the same level indefinitely. C. maintaining a steady progression of dividend increases over time. D. alternating cash dividends with stock dividends. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividends and payout policy

37.

How are investors most apt to interpret a reduction in a firm's regular dividend payment? A. Earnings are expected to decline. B. New investments are expected to increase. C. Stock repurchases are expected to increase. D. Share price is expected to increase. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividends and payout policy

38.

What is the new share price for a corporation with a current share price of $4 that employs a 2-for-9 reverse split? A. $8 B. $16 C. $36 D. $18 New price = 9 / 2 × $4 = $18

39.

If investors are expecting a dividend cut, then the announcement of the decreased dividend payment will: A. cause the stock price to decline by more than the dividend amount. B. not affect the stock price as long as the announcement was in line with expectations. C. cause the stock price to increase if the cut was greater than anticipated. D. signal that the next dividend will be cut even further. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

40.

MM's proposition of dividend irrelevance depends upon: A. firms maintaining a constant dividend payout. B. dividends being taxed the same as capital gains. C. the existence of a dividend clientele. D. the efficiency of capital markets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

41.

A firm has $250,000 to spend on either a one-time special dividend or on a share repurchase program. If the share repurchase is selected, then the firm's: A. value will decrease just as if the dividend option had been selected. B. balance sheet will be unaffected and the share price will remain constant. C. equity balance will be reduced by less than it would have been under the dividend option. D. shareholders will receive less value than under the dividend option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

42.

Based on the dividend growth model, a lower current payout will not affect the stock price, provided that the: A. required return on the stock is proportionately increased. B. growth rate in dividends remains constant. C. reduction is offset by an increase in the growth rate. D. growth rate is decreased by the percent decrease in the dividend. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividends and payout policy

43.

Why are dividend changes rather than the absolute level of dividends perceived to be more important to managers and shareholders? A. Managers change dividends only under threatening conditions. B. Dividend changes are thought to signal future expectations. C. MM's argument states that the absolute level of dividends is irrelevant. D. Dividend changes determine whether borrowing must occur. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

44.

Which one of the following signals is most likely to elicit a decrease in share price? A. A repurchase of 5% of the firm's stock B. An increase in the regular quarterly dividend C. A decrease in the regular quarterly dividend D. Borrowing funds in order to pay a cash dividend AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

45.

An increase in share price following an increase in dividends is logical if the: A. firm borrows to obtain cash for the dividend. B. increased dividend signals higher future earnings. C. dividend is believed to be temporary. D. clientele effect is not important. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

46.

Which one of these parties is most likely to prefer a stock with a high-dividend payout policy? A. Financial institutions B. Retired individuals C. Growth-seeking investors D. Endowment funds AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

47.

An investor buys a stock today for $26, receives a dividend of $2 at the end of the year and then sells the stock for $30. If the dividend is taxed at 40% and the capital gain at 20%, what is his return after tax? A. 23.08% B. 16.92% C. 9.23% D. 31.15% ($2 + ($30 − $26) − (0.4 × $2) − (0.2 × $4)) / $26 =0.1692, or 16.92%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 17-04 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy. Topic: Tax effects on dividends and payouts

48.

What is the difference in the one-year after-tax returns on the following two stocks, assuming a 40% tax rate on dividends and a 20% tax rate on capital gains? Stock A is purchased for $50, pays a $2.5 dividend at the end of the year, and is then sold for $56; stock B is purchased for $60, pays no dividend, but is sold after one year for $70. A. Stock A's after-tax return is higher by 1.27%. B. Stock B's after-tax return is higher by 0.73%. C. Stock A's after-tax return is higher by 0.27%. D. Stock B's after-tax return is higher by 0.58%. RA = [($2.5 + $56 − $50) − (0.4 × $2.5) − (0.2 × $6)] / $50 = 0.1260, or 12.60% RB = [($70 − 60) − (0.2 × $10) / $60] = 0.1333, or 13.33% Difference = 13.33% − 12.60 = 0.73%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-04 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy. Topic: Tax effects on dividends and payouts

49.

A company is more likely to repurchase stock rather than pay out dividends when the firm: A. wants to distribute excess cash by making a regular commitment to its investors. B. wants to conserve current cash. C. wants to avoid a commitment for future distributions. D. foresees excess cash as a common long-term occurrence. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

50.

Capital gains may be preferred by investors over dividends even if dividends and capital gains are taxed at the same rate because: A. taxes on dividends are withheld immediately. B. taxes on capital gains are paid annually. C. taxes on capital gains can be deferred. D. after-tax dividends are less certain than capital gains. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-04 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy. Topic: Tax effects on dividends and payouts

51.

Compare the after-tax returns for a corporation that invests in preferred stock with a 12% dividend yield versus a common stock with no dividend but a 16% capital gain. The corporation's tax rate is 35%. The: A. common stock returns 2.60% more than the preferred. B. preferred stock returns 0.34% more than the common. C. common stock returns 2.32% more than the preferred. D. returns are equal on an after-tax basis. After-tax returns: RP = 0.12 − (0.12 × 0.30 × 0.35) = 0.1074, or 10.74% RC = 0.16(1 − 0.35) = 0.1040, or 10.40% Difference = 10.74% − 10.40 = 0.34%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Topic: Tax effects on dividends and payouts

52.

Why may a large increase in earnings not translate into a large increase in dividends? A. The earnings will be taxed. B. Some investors may prefer capital gains. C. Managers wish to assess the earning's persistence. D. The earnings may already be a part of retained earnings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividends and payout policy

53.

You purchased a stock today. What should you expect if the stock goes ex-dividend tomorrow? A. A dividend will be declared tomorrow. B. A dividend will be paid tomorrow. C. The stock price should decline tomorrow. D. The stock price has already adjusted for the next dividend payment. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

54.

With respect to the dividend-payment process, the price of a share of stock can logically be expected to drop on: A. the payment date. B. the date of record. C. the ex-dividend date. D. the declaration date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

55.

Automatic dividend reinvestment plans allow firms to: A. pay dividends on a more frequent schedule. B. reduce their cash outflow to shareholders. C. transform regular dividends into stock dividends. D. avoid the ex-dividend date reduction in stock price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividend reinvestment plans

56.

Evenglade Corp has 1,000 shares outstanding priced at $10 a share. The company is unsure whether to pay out $1 a share as a dividend or to use the money to repurchase stock. If it pays a dividend, what happens to the stock price? If it repurchases, how many shares will remain and at what price? A. After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price falls to $9. B. After the dividend payment stock price falls to $9. If Evenglade repurchases, 800 shares remain and the share price stays at $10. C. After the dividend payment stock price falls to $9. If Evenglade repurchases, 900 shares remain and the share price stays at $10. D. After the dividend payment stock price stays at $10. If Evenglade repurchases, 900 shares remain and the share price rises to $11.11. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

57.

Firm X will a dividend of $10 next year and its stock is expected to sell at $100 after the payment. Firm Y pays no dividend but its stock is expected to sell at $110. Dividends are taxed at 30% and capital gains are untaxed. If both stocks offer an after-tax return of 8%, what is the price of the two stocks? A. Price of X = $101.85; price of Y = $101.85 B. Price of X = $99.07; price of Y = $101.85 C. Price of X = $100; price of Y = $101.85 D. Price of X = $99.07; price of Y = $100 Price X = ($100 + (1 − 0.3) × $10) / 1.08 = $99.07; Price of Y = $110 / 1.08 = $101.85

58.

What effect does a stock dividend have on the book and market values of the firm? A. Both the book and market values increase B. Book value increases; market value decreases C. Book value decreases; market value increases D. Both the book and market values remain constant AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock dividends

59.

An investor owns 300 shares of stock currently selling for $70 per share. After a 3-for-2 stock split, the investor will have: A. 200 shares selling for $93.10 each. B. 200 shares selling for $105.00 each. C. 450 shares selling for $46.67 each. D. 450 shares selling for $93.10 each. New shares = 300 × 3 / 2 = 450 shares New price = $70 × 2 / 3 = $46.67

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Stock splits

60.

When a corporation engages in a 10% stock repurchase, it: A. offers shareholders 110 shares for every 100 they currently own. B. purchases for cash 10% of the outstanding shares. C. sells treasury stock at a 10% discount to investors. D. issues 10% more stock but holds the shares as treasury shares. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Stock repurchases

61.

A share repurchase is said to be equivalent to the payment of a cash dividend because each strategy: A. causes share price to decline. B. causes share price to remain constant. C. creates the same tax liability for the investor. D. reduces the assets of the firm by the same amount. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Stock repurchases

62.

Assuming no market imperfections, which one of the following will not be affected by a repurchase of shares? A. Assets of the firm B. Equity of the firm C. Shares outstanding D. Price per share AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

63.

Assuming no market imperfections, which one of the following would not be expected to have an effect on share price? A. Dividend declaration and payment B. Stock repurchase C. Stock dividend D. Stock split AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

64.

Which one of the following is correct for a firm with $400,000 in net earnings, 50,000 shares, and a 30% payout ratio? A. Retained earnings will increase by $120,000. B. Each share will receive a $1.20 dividend. C. $120,000 will be spent on new investments. D. The dividend per share will be $2.40. DPS = (0.30 × $400,000) / 50,000 = $2.40

65.

A firm is said to be "smoothing" dividends if dividends: A. are paid through an automatic dividend reinvestment plan. B. change more gradually than changes in earnings. C. increase by the same dollar amount each year. D. are paid only in even dollar amounts. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividends and payout policy

66.

Managers have been characterized as reluctant to increase dividends if: A. dividends were increased in the preceding year. B. earnings have permanently increased. C. the dividend increase cannot be sustained. D. the dividend payout ratio exceeds 20%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividends and payout policy

67.

Dividend changes are typically viewed by investors as signals of future changes in: A. investment. B. the firm's WACC. C. earnings. D. the clientele effect. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividends and payout policy

68.

An unlevered firm expects to generate and payout free cash flows of $120,000 annually in the form of dividends and share repurchases starting next year. The discount rate is 13% and there are 125,000 shares outstanding. What is the current value per share? A. $7.38 B. $0.96 C. $1.08 D. $6.87 Share price = ($120,000 / 0.13) / 125,000 = $7.38

69.

B Corp has announced four dates (payment date, ex-dividend date, announcement date and record date) associated with its forthcoming dividend. The dates are August 1, October 1, August 30 and August 28. Which one of these dates is the record date and which is the ex-dividend date? A. Record date = October 1, ex-dividend date = August 30. B. Record date = August 28, ex-dividend date = August 30. C. Record date = August 1, ex-dividend date = August 28. D. Record date = August 30, ex-dividend date = August 28. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

70.

MM's proposition concerning dividends contends that shareholders will: A. offer higher prices for higher dividend payouts. B. not offer higher prices for higher dividend payouts. C. offer higher prices for lower dividend payouts. D. purchase only stocks that have high dividend payouts. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Payout policy observations

71.

MM's assertion that dividend policy will not affect the value of the firm requires that dividend policy does not: A. alter the retained earnings of the firm. B. affect investment and borrowing policies. C. allow the payout ratio to change. D. alter the number of outstanding shares. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

72.

The manager of XYZ Corp. feels that a dividend increase will increase the stock price because many investors value stock with a dividend-discount model. Why might MM disagree with this assertion? A. The increased dividend makes the firm much riskier. B. If investment policy is to remain unchanged, the company will need to replace the cash with a stock issue. C. Investors prefer capital gains over dividends. D. Dividend increases will increase the book value but not the market value of the firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy

73.

Market imperfections may make the choice between dividends and repurchases relevant. Which of the following is not one of these imperfections? A. Institutional restrictions on stock holdings B. Differences in dividend-payout ratios C. Taxes on dividends and capital gains D. Differences among investors in marginal tax rates AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-04 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy. Topic: Dividend policy

74.

A stock is currently priced at $65 per share and will pay a $4 dividend in one year. What must the stock sell for in one year to meet investors' expectations of a 15% after-tax return if dividends are taxed at 28% and there are no capital gains taxes? A. $70.75 B. $71.87 C. $73.63 D. $76.00 0.15 = ($4 / $65)(1 − 0.28) + (P1 − $65) / $65; P1 = $71.87

75.

Corporations may have a legitimate preference for dividends over capital gains because: A. capital gains have a 50% tax rate. B. dividends received by corporations are not taxable. C. 30% of dividends received by corporations are exempt from taxation. D. 70% of dividends received by corporations are exempt from taxation. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-04 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy. Topic: Tax effects on dividends and payouts

76.

Stock A has a dividend yield of 8% but no capital gain. Stock B offers a capital gain but no dividend. If a corporate investor in the 35% tax bracket earns the same after-tax return from the two stocks, what capital gain does B offer? A. 8.00% B. 9.29% C. 11.02% D. 12.31% RA = 0.08 − (0.08 × 0.30 × 0.35) = 0.0716, or 7.16% RB = 0.0716 / (1 − 0.35) = 0.1102, or 11.02%

77.

The date on which actual dividend checks are mailed to shareholders is the: A. declaration date. B. payment date. C. ex-dividend date. D. record date. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

78.

An investor who owns stock on the company's __________ date will receive the dividends declared. A. ex-dividend B. record C. payment D. declaration AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

79.

Which one of the following is the order in which key dividend dates occur? A. Declaration, record, ex-dividend, payment B. Declaration, ex-dividend, record, payment C. Record, declaration, payment, ex-dividend D. Ex-dividend, record, declaration, payment AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Chronology of dividend payments

80.

A corporation that has an automatic reinvestment plan: A. forces shareholders to automatically reinvest dividends in the company. B. never physically pays out declared dividends. C. gives shareholders the option of purchasing either debt or equity shares. D. gives shareholders the option to re-invest the dividend in additional shares. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividend reinvestment plans

81.

The primary purpose of laws prohibiting a firm from paying dividends that include its legal capital is to: A. reduce investors' tax liability. B. ensure that the balance sheet balances. C. prevent managers from paying out a substantial proportion of the firm's assets. D. prevent managers from paying large dividends. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividends and payout policy

82.

Kappa Corp has just raised its dividend from $2.50 to $5 per share. (It plans to reduce its repurchases by a similar amount.) Caterina Chekov, who owns 100 shares of Kappa does not need the extra cash. What can she do to offset the change in dividend policy? A. reinvest the extra dividend in Kappa stock. B. sell $250 of Kappa stock each year. C. borrow $250 and invest it in Kappa stock. D. Nothing. She should sell out and invest elsewhere. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

83.

Kappa Corp and Lambda Corp are identical except that Kappa pays a dividend of $5 per share, while Lambda pays no dividend and uses the cash to repurchase stock. Peter Berngarten owns 100 shares of Kappa. How could he raise the same amount of spending money if instead he owned 100 shares of Lambda? A. He could sell $500 worth of shares of Lambda each year. B. He couldn’t; he could not be sure of the price at which he could sell Lambda stock. C. He could sell 5 shares of Lambda each year. D. He could borrow against his holding of Lambda stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

84.

Zeta Corp has 1,000 shares outstanding. Its stock is priced at $100 a share and shareholders expect Zeta to pay dividends of $10 a year in perpetuity. Now the president suddenly announces that it will keep the total payout the same but will pay only a quarter of the total amount as dividends and use the remaining cash to buy back stock. What will happen to the share price now and how much will the share price grow each year? A. The value of the shares will be unchanged by the announcement and will not grow.0%. B. The share price will be unchanged by the announcement. Subsequently the share price will grow by 7.5% each year. C. The share price will halve and then grow by 7.5% a year. D. The share price will be unchanged by the announcement and will decline by 10% a year. The share price will be unchanged. Repurchases will cause the number of shares and dividend per share to rise by 7.5% a year. PV = $2.5 / (0.10 − 0.075) = $100.

85.

Which one of the following statements regarding stock dividends and stock splits is true? A. A two-for-one stock split is equivalent to a 50% stock dividend. B. A three-for-one stock split is equivalent to a 66% stock dividend. C. A three-for-two stock split is equivalent to a 100% stock dividend. D. A three-for-two stock split is equivalent to a 50% stock dividend. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock splits

86.

Stock repurchases: A. decrease the number of authorized shares. B. affect every shareholder. C. are optional to the shareholders. D. always increase shareholder value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

87.

Research has shown all of the following to be true of the way corporations determine dividends except: A. Firms have short-run target payout ratios. B. Firms have long-run target payout ratios. C. The focus is more on dividend changes rather than absolute dividends. D. Managers try to avoid dividend changes that may need to be reversed. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividends and payout policy

88.

Which of the following statements is false? A. Most mature companies pay dividends. B. Many companies pay dividends and repurchase stock. C. Repurchases fluctuate more than dividends. D. Stock repurchases have become less common over the past 30 years. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividends and payout policy

89.

Given a set investment policy and capital structure, then payout policy is a trade-off between ___________ and ___________. A. retained earnings; borrowing B. capital budgeting; cash dividends C. cash dividends; stock issues and repurchases D. stock splits; stock dividends AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividends and payout policy

90.

Which statement is correct? A. the dividend discount model is no longer applicable when there are stock repurchases. B. when valuing free cash flow per share it is important to include both dividends per share and the cash received from repurchases. C. shareholders like dividends because it is the only way that they can get their hands on cash. D. if capital investment and capital structure are held constant, smaller dividends mean larger repurchases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

91.

With respect to the proposition that dividend policy does not matter, in order to raise an additional $5,600 in cash by issuing stock, the stock sold must be worth: A. more than $5,600. B. $2,800. C. $5,600. D. less than $5,600. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Dividend policy irrelevance

92.

The Beta Corporation has 1,000 shares outstanding and a market value of $90,000. What will be the market value per share after the firm distributes a $5 per share dividend? Ignore taxes and market imperfections. A. $90 B. $85 C. $80 D. $87.50 New share price = ($90,000 / 1,000) − $5 = $85

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Cash dividends

93.

Q Corp has decided to pay out an extra $1 million to shareholder, while keeping investment policy and capital structure constant. Which statement is false? A. Q Corp must issue $1 million of stock to replace the lost cash. B. the new shareholders will demand to receive shares worth $1 million. C. the old shareholders will have reduced their stake in the firm by $1 million. D. the reduced stake that old shareholders have in the firm will more than offset the benefit of the higher dividend. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets. Topic: Dividend policy irrelevance

94.

A dividend increase may be used as __________ of a firm's __________. A. an indicator; high capital gains B. an indicator; tax liability C. a signal; poor prospects D. a signal; good prospects AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news. Topic: Dividends and payout policy

95.

Which party receives the greatest tax benefit from receiving dividends rather than capital gains? A. Individual investors B. Corporations C. Financial institutions D. Foundations AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Tax effects on dividends and payouts

96.

Which of the following statements is correct? A. Investors rightly prefer repurchases because the reduced number of shares increases earnings per share. B. Companies with large repurchase programs usually finance them by a cut in dividends. C. Companies pay out as dividends whatever is left over after making needed capital investments. D. A stock repurchase does not increase stock price but it does avoid the fall in price that would occur on the ex-dividend date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased. Topic: Stock repurchases

97.

In MM's analysis, which one of these is not fixed? A. Debt payments B. Investment policy C. Capital structure D. Payout decisions AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm.

Topic: Dividends and payout policy

98.

Three of the following considerations may suggest that the firm should start paying out cash to its shareholders. Which one is not a relevant consideration? A. Is the company generating positive free cash flow? B. The company is earning a high profit margin? C. Does the company have sufficient cash for emergencies and unexpected investment opportunities? D. Is the debt ratio prudent? AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Topic: Payout policy considerations

99.

Which one of these firms would you most expect to have the highest payout percentage? A. New technology firm B. Mature firm in a declining industry C. Mature firm with limited growth opportunities D. Rapidly expanding firm in a growth industry AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Topic: Payout policy considerations

100.

Under which conditions are shareholders most likely to be concerned about agency conflicts? A. Growth firm with financing needs that use most of the firm's available cash flows B. Young firm with negative free cash flows C. Large free cash flows generated by a mature firm D. Mature firm with a low retention ratio and frequent stock repurchases AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm. Topic: Agency costs and problems

Chapter 17 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

100

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

100

Learning Objective: 17-01 Describe how dividends are paid and shares are repurchased.

Learning Objective: 17-02 Explain why dividend increases and repurchases are good news for investors and why dividend cuts are bad news.

Learning Objective: 17-03 Explain why payout policy would not affect shareholder value in perfect and efficient financial markets.

Learning Objective: 17-04 Show how market imperfections, especially the different tax treatment of dividends and capital gains, can affect payout policy.

Learning Objective: 17-05 Understand how payout policy varies over the life cycle of the firm.

Topic: Agency costs and problems

Topic: Cash dividends

Topic: Chronology of dividend payments

Topic: Dividend policy

Topic: Dividend policy irrelevance

Topic: Dividend policy observations

Topic: Dividend reinvestment plans

Topic: Dividends and payout policy

Topic: Payout policy considerations

Topic: Payout policy observations

Topic: Stock dividends

Topic: Stock repurchases

Topic: Stock splits

Topic: Tax effects on dividends and payouts

Topic: Zero-growth stock

Chapter 18 Test bank - Static Student: ___________________________________________________________________________

A planning horizon refers to the amount of time necessary to develop the financial plan. True

A common, long-term corporate financial planning horizon would stretch for at least 15 to 20 years. True

False

Financial planning should attempt to minimize risk. True

False

Financial planning is concerned with possible surprises as well as the most likely outcomes. True

False

The primary aim of financial planning is to obtain better forecasts of future cash flows and earnings. True

False

Financial planning may incorporate scenario analysis as part of the planning process. True

False

Financial planning focuses on the big picture. True

False

Financial plans will rarely succeed unless the forecasts are perfect. True

False

Financial planning is necessary because financing and investment decisions interact and should not be made independently. True

False

10. A typical horizon for long-term planning is 5 years. True

False

11. Individual capital investment projects are not considered in a financial plan unless they are very large. True

False

12. Financial planning requires careful and consistent forecasting. True

False

13. Financial planning models must include as much detail as possible. True

False

14. The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio. True

False

15. Financial planning just means formulating the company's response to the most likely events. True

False

16. Adaptability is not a desirable feature in financial plans. True

False

17. Pro formas are projected or forecasted financial statements. True

False

18. Percentage of sales models are planning models in which the sales forecasts are the driving variables and most other variables are proportional to sales. True

False

19. The balancing items in a financial planning model are variables that adjust to maintain the consistency of the model. They are also known as plugs. True

False

20. Debt can be used as a plug item in financial planning. True

False

21. Financial models identify the best financing plan. True

False

22. The decision to acquire fixed assets is unrelated to the current level of excess capacity. True

False

23. Financial planning models routinely adjust for present value and risk. True

False

24. If factories are operating below full capacity, sales can increase without investment in fixed assets. However, beyond some sales level, new capacity must be added and additional investment in fixed assets must be made. True

False

25. A financial planning model will generally include all of the following except the: A. listing of the firm's goals. B. required increase in fixed assets. C. projected sales. D. forecast increase in retained earnings. 26. Planners often recommend entering a market for "strategic" reasons because the: A. company is facing too much competition in its original market. B. company may have valuable follow-on investments in the new market. C. immediate investment has a positive net present value. D. manager has a personal interest in a particular market. 27. Which one of the following is not typically included among the three major components of a financial planning model? A. Inputs: current financial statements, forecasts of key variables B. Planning model: equations specifying key relationships C. Outputs: pro formas, financial ratios, sources and uses of cash D. Shareholders’ risk preferences 28. Which one of the following is not a reason for compiling financial plans? A. Considering options B. Contingency planning C. Calculating the optimal plan D. Forcing consistency 29. Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is 70%, equity outstanding at the beginning of the year is $940,000, and its net income for the year is $162,000. A. 5.17% B. 11.67% C. 14.00% D. 16.67% 30. The firm's current financial statements would be included in: A. the inputs of a financial plan. B. the planning model for the financial plan. C. the outputs of the financial plan. D. no part of the financial plan. 31. The implications of the forecasts from a financial plan are determined by the: A. plan inputs. B. balancing item. C. planning model. D. plowback ratio.

32. Pro formas refer to: A. plans developed by a certified financial planner. B. the inputs in the financial planning process. C. projected financial statements. D. deviations in results from previous financial plans. 33. Outputs from a financial plan would include such items as: A. sales growth forecasts. B. a percentage of sales planning model. C. a pro forma statement of sources and uses of cash. D. the firm's current financial statements. 34. When most of the elements of a financial plan are related to sales levels, the plan is: A. less likely to be effective. B. using sales as a plug figure. C. a percentage of sales model. D. not adjusted for inflation. 35. A planner's percentage of sales model forecasts that sales will grow by 20% next year. If costs of goods sold are proportionate at 70% of sales, then costs of goods sold will: A. grow to 90% of sales. B. grow in dollars by 70%. C. not change in dollar amount. D. increase by 20% in dollar terms. 36. When a firm has no spare capacity, it: A. has no need for new employees. B. currently has no inventory available for sale. C. must issue new equity to grow. D. must usually increase fixed assets to increase sales. 37. If the pro forma balance sheet shows that total assets must increase by $400,000 while retaining a debt-equity ratio of 0.75 then: A. debt must increase by $300,000. B. equity must increase by the full $400,000. C. debt must increase by $171,429. D. equity must increase by $100,000. 38. If sales growth for XYZ Corporation exceeds 6%, XYZ will need to seek external financing. This means that 6% is the: A. external growth rate. B. internal growth rate. C. optimal growth rate. D. sustainable growth rate.

39. If a firm's dividend payout ratio is determined after achieving a specific capital structure, then: A. dividends are an input to the financial plan. B. the capital budget should be revised. C. dividends are being used as a plug item. D. dividend forecasts become crucial to planning. 40. A firm has $4 million in total assets and $2.2 million in equity. How much of its $500,000 capital budget should be debtfinanced to retain the same debt-equity ratio? A. $50,000 B. $225,000 C. $275,000 D. $450,000 41. If a firm uses external financing as a plug item, has a new capital budget of $2 million, a net income of $3 million, and a plowback ratio of 40%, how much should be raised in external funds? A. $200,000 B. $600,000 C. $800,000 D. $1,200,000 42. A potential downside to using dividends as the plug item is that: A. changes in dividends may send shareholders mixed signals. B. the plan may suggest negative dividends. C. the firm may have to borrow cash to pay dividends. D. shareholders may receive an excessive return. 43. A firm that wants to increase its sustainable growth rate can do so by __________ the __________ ratio or by __________ the __________, or both. A. increasing; payout; increasing; ROE B. increasing; plowback; increasing; ROE C. decreasing; plowback; increasing; ROE D. decreasing; payout; decreasing; ROE 44. Alternative "what if?" scenarios can be easily accommodated in financial planning by use of: A. sustainable growth models. B. planning outputs. C. spreadsheet programs. D. bond covenants. 45. A firm currently has sales of $382,000 and net working capital of $45,840. Assume net working capital changes in direct proportion to sales. What will be the increase in net working capital if sales increase by 8%? A. $1,222 B. $2,809 C. $3,091 D. $3,667

46. The observation that additions to fixed assets are lumpier than additions to current assets indicates that: A. fixed assets depreciate over time. B. fixed assets can be acquired only through external funding. C. current assets can be acquired in smaller increments. D. dollar for dollar, fixed assets are more expensive than current assets. 47. A firm can achieve a higher growth rate without raising external capital if it: A. has a high dividend payout ratio. B. has a low ROE. C. has a low debt-to-asset ratio. D. has a low profit margin. 48. Other things equal, a firm can grow more rapidly without raising new capital if: A. it has a low ROE. B. it has a high ratio of debt to assets. C. it has a low profit margin. D. it pays out a small proportion of earnings. 49. If a firm with an asset base of $3 million recently added $150,000 to retained earnings after a dividend payment of $100,000, then its internal growth rate is: A. 1.67%. B. 3.33%. C. 5.00%. D. 8.33%. 50. What is the maximum internal growth rate for a firm reporting net income of $500,000, a dividend payout ratio of 40%, and total assets of $10 million? A. 2% B. 3% C. 5% D. 6% 51. A firm plans to grow at 6% a year without increasing financial leverage. It expects to earn a 10% return on equity. What proportion of earnings should it plan to pay out? A. 0.40 B. 0.60 C. 0.67 D. 0.00 52. A firm has an ROE of 15% and a debt-equity ratio of 40%. If it wishes to grow by 9% a year without external financing, what is the maximum proportion of earnings that it can pay out? A. 1% B. 10% C. 12% D. 16%

53. Which one of the following will reduce the internal growth rate, other things equal? A. A higher plowback ratio B. A higher debt-to-asset ratio C. A higher return on equity D. A higher return on assets 54. What is the sustainable growth rate for a firm with net income of $2.5 million, cash dividends of $1.5 million, and return on equity of 18%? A. 3.0% B. 5.4% C. 7.2% D. 10.8% 55. The sustainable rate of growth assumes that the: A. debt-equity ratio is held constant. B. market to book ratio increases. C. dividend payout ratio decreases. D. external debt remains constant. 56. A firm has a policy of not issuing debt and paying out 40% of its earnings. Its asset turnover is 2.0 and its profit margin is 10%. What is its sustainable growth rate? A. 20.0% B. 8.0% C. 3.0% D. 12.0% 57. A firm has sales of $1.2 million, a profit margin of 5%, and a dividend payout ratio of 25%. How much will be added to retained earnings next year if sales increase by 6%? A. $15,900 B. $21,600 C. $47,700 D. $42,000 58. Short-term financial rarely look beyond: A. 1 year. B. 1 month. C. 1 week. D. 1 day. 59. If the projected growth rate is less than the firm's sustainable growth rate: A. it should increase its projected growth rate. B. the firm will be required to decrease its plowback ratio. C. its debt-equity ratio will decrease. D. the firm will be required to increase borrowing.

60. Contingency planning is: A. forecasting the most likely outcomes. B. working through the implications of the most likely outcomes. C. working through the consequences of the plan under different scenarios. D. formulating responses to inevitable surprises. 61. A major difference between financial planning and forecasting is that financial planning: A. is forward-looking. B. relies on the preferences of management. C. determines the rate of profitability. D. is equally concerned with less likely outcomes. 62. A firm has current sales of $2.4 million and fixed assets of $1.65 million. The firm is currently operating at 88% of capacity. How high can the firm's sales go without requiring any additional fixed assets? A. $2.423 million B. $2.509 million C. $2.727 million D. $2.836 million 63. The flexibility of financial plans is evident in the extent that: A. actual profits will deviate from projected profits. B. the plans can be adapted when conditions change. C. use of the plans can be extended. D. planning output is the same regardless of economic conditions. 64. Dawson Metals is currently operating at 94% of its capacity and has sales of $3.1 million and fixed assets of $2.5 million. How much should the firm budget for fixed asset purchases if sales are projected to increase by 9% next year? A. $0 B. $61,500 C. $43,616 D. $98,407 65. The outputs of a financial planning model often include: A. the firm's current financial statements. B. a range of macroeconomic forecasts. C. the number of employees required. D. projected financial statements of the firm. 66. Planners have determined that sales will increase by 20% next year, and the profit margin will remain at 10% of sales. Which one of the following statements is correct if the payout ratio remains at 30%? A. Net income will increase by 10% next year. B. The addition to retained earnings will increase by 20% next year. C. The dividend will increase by 6% next year. D. The addition to retained earnings will equal 6% of the sales increase next year.

67. A percentage-of-sales model forecasts that cost of goods sold will remain at 80% of sales. If sales revenues are expected to grow by 20% next year, cost of goods sold: A. will grow by 16%. B. will grow by 20%. C. could grow either faster or slower than sales. D. will remain constant. 68. A firm's goal is to maintain a 75% debt-equity ratio. How much equity would be required if the results of a financial planning model indicate that the firm's assets will grow to $4 million? A. $1.00 million B. $1.71 million C. $2.29 million D. $3.00 million 69. If a firm commits to a dividend payment and the amount of debt that it is prepared to issue, what must be the balancing item? A. the profit margin. B. new equity issues. C. cost of goods sold. D. return on equity. 70. The final variable to have its value determined in a financial plan is often referred to as the: A. net income. B. balancing item. C. retained earnings plowback. D. growth forecast. 71. Which one of the following is most apt to occur if a financial plan shows sources of funds to be $100,000 and uses of funds to be $90,000? A. External debt of $10,000 will need to be raised. B. Dividend payments will be decreased by $10,000. C. Cash balances will be increased by $10,000. D. The capital budget will be decreased by $10,000. 72. Increased needs for net working capital are: A. recognized in pro forma balance sheets. B. totally absorbed by retained earnings. C. typically financed with short-term debt. D. ignored due to their great variability. 73. How much is required in external financing if first-stage pro forma statements indicate $1 million in net income, $300,000 in dividends, and a $900,000 increase in total assets? A. $200,000 B. $500,000 C. $600,000 D. No external financing is required.

74. If a firm's pro forma statements project a net income of $5,000, dividends of $2,000, and an external financing requirement of $2,000, then: A. The firm must issue new equity. B. The profit margin has declined. C. Total assets need to grow by $5,000. D. The internal growth rate is 15%. 75. The first step in constructing a financial planning model is to: A. determine the mix of securities that the company will need to issue. B. determine the amount of external financing that is needed. C. determine what additional fixed assets the company will need. D. project future cash flows from operations. 76. The rate at which the assets of a firm can grow without the requirement of any external sources of financing is the: A. internal growth rate. B. sustainable growth rate. C. pro forma growth rate. D. plowback rate. 77. Which one of the following statements is correct concerning the internal growth rate? A. It is maximized when the payout ratio equals zero. B. It is maximized when the plowback ratio equals zero. C. It cannot be less than the sustainable growth rate. D. It decreases as total assets decrease. 78. Which one of the following changes will decrease a firm's internal growth rate? A. A decrease in dividends with a given net income B. An increase in net income with a given dividend payout ratio C. A decrease in the plowback ratio D. A decrease in assets with a set dividend payout ratio 79. Under which one of the following capital structures will a firm's internal growth rate exceed its sustainable growth rate? A. Total debt-to-asset ratio equals 35%. B. Equity-to-debt ratio equals 60%. C. Equity-to-debt ratio equals 125%. D. None of the options. 80. What would help a firm boost its internal growth rate? A. Plowing back a low proportion of its earnings B. Achieving a high return on equity C. Decreasing reinvested earnings D. Maintaining a low sales-to-total assets ratio

81. The sustainable growth rate is the maximum growth rate that the firm can achieve A. without external financing. B. while maintaining its debt ratio. C. without investing in additional fixed assets. D. without excessive strains on management. 82. The sustainable growth rate: A. increases as ROE decreases. B. increases as the payout ratio decreases. C. is maximized when the plowback ratio equals zero. D. cannot be greater than the internal growth rate. 83. What is the sustainable growth rate for a firm with $250,000 in net income, $100,000 in common stock dividends, and equity of $1 million? A. 8% B. 10% C. 15% D. 17% 84. What is the internal growth rate for a firm with an ROE of 20%, a dividend payout ratio of 40%, and an equity-to-debt ratio of 60%? A. 4.50% B. 5.39% C. 8.00% D. 12.00% 85. Which one of the following would increase the sustainable growth rate? A. Reduce the ROE. B. Increase the asset beta. C. Reduce the payout ratio. D. Reduce the operating leverage. 86. All of the following are part of the financial planning process except: A. deciding which risks are worth taking. B. analyzing investment and financing options. C. projecting the future. D. minimizing risk. 87. Which one of these is least likely to change proportionally with sales? A. Depreciation B. Investment in receivables C. Cost of goods sold D. EBIT

88. A firm's internal growth rate is all of the following except: A. the rate below which external financing is needed. B. the ratio of reinvested earnings to assets. C. the maximum growth rate without requiring external sources of new capital. D. the product of the plowback ratio, ROE, and the ratio of equity to assets. 89. A financial plan: A. is generally considered to be a useless exercise due to unforeseen events. B. should include all possible contingencies. C. provides a basis for evaluating future performance. D. should always be based on the worst-case scenario. 90. In the percentage of sales model, which one of these is most likely to increase in uneven increments as sales increase? A. Cost of raw materials B. Accounts receivable C. Accounts payable D. Fixed assets 91. Which one of these best describes the relationship between net working capital (NWC) and sales? A. NWC will change by the same percentage as sales. B. NWC is unaffected by changes in the sales level. C. NWC changes by a greater percentage than the change in sales, but the change is linear in nature. D. NWC changes in direct relation to sales, but the change may be less than proportional with sales. 92. A percentage of sales model projects sales to increase by 5% annually over the next 4 years. If costs are forecast at a constant 80% of sales, and this year's income is $1,250, the forecast income in the fourth year will be: A. $1,447.03. B. $1,826.15. C. $1,595.35. D. $1,519.38. 93. If a firm's sales increase by 12%, and it has no spare capacity, it must increase fixed assets by at least: A. 0%. B. 6%. C. 9%. D. 12%. 94. If book equity increases by $2,000, the firm does not issue new equity, and its net income is $2,500, then: A. the firm paid a dividend of $500. B. the firm plowed $500 back into the company. C. $500 went into retained earnings. D. debt increased by $2,000.

95. Sources and uses of funds are made equal through: A. a balancing item. B. pro forma financial statements. C. borrowed cash. D. additions to retained earnings. 96. Which one of the following statements regarding financial planning models is false? A. The models should include as much detail as possible. B. The results of a model are pro forma financial statements. C. The plug variable maintains consistency. D. Financial analysis is not used in financial planning. 97. Which one of the following is not an output of a financial plan? A. Financial ratios B. Pro forma statements C. Sources and uses of cash statement D. Sales forecasts 98. If a firm does not want to use either dividends or debt as the plug, then the obvious plug is: A. inventory B. cash C. new issue of equity D. fixed assets 99. A firm has projected sales of $328,000, costs of goods sold equal to 68% of sales, interest of $18,500, a tax rate of 35%, and a dividend payout ratio of 60%. What will be the addition to retained earnings? A. $16,667 B. $22,480 C. $24,002 D. $19,531 100. Assume a firm wants to hold its current long-term debt-to-equity ratio constant at 0.55 and its payout ratio constant at 35%. The firm neither issues nor repurchases shares. If the firm generates $326,000 of net income, what is the maximum amount that the firm can increase its long-term debt? A. $116,545 B. $95,355 C. $122,615 D. $0 101. A firm's net assets equal 55% of sales. The firm expects sales to increase of $78,000 next year and to generate $6,500 of retained earnings. What is the external financing need? A. $49,400 B. $21,200 C. $28,600 D. $36,400

Chapter 18 Test bank - Static Key 1.

A planning horizon refers to the amount of time necessary to develop the financial plan. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

A common, long-term corporate financial planning horizon would stretch for at least 15 to 20 years. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

Financial plans will rarely succeed unless the forecasts are perfect. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

Financial planning focuses on the big picture. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

Financial planning may incorporate scenario analysis as part of the planning process. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium

Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

The primary aim of financial planning is to obtain better forecasts of future cash flows and earnings. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

Financial planning is concerned with possible surprises as well as the most likely outcomes. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

Financial planning should attempt to minimize risk. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

Financial planning is necessary because financing and investment decisions interact and should not be made independently. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

10.

A typical horizon for long-term planning is 5 years. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

11.

Individual capital investment projects are not considered in a financial plan unless they are very large. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

12.

Financial planning requires careful and consistent forecasting. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

13.

Financial planning models must include as much detail as possible. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

14.

The sustainable growth rate is the rate at which the firm can grow without changing its leverage ratio. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Internal and sustainable growth rates

15.

Financial planning just means formulating the company's response to the most likely events. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

16.

Adaptability is not a desirable feature in financial plans. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

17.

Pro formas are projected or forecasted financial statements. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Pro forma statements

18.

Percentage of sales models are planning models in which the sales forecasts are the driving variables and most other variables are proportional to sales. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

19.

The balancing items in a financial planning model are variables that adjust to maintain the consistency of the model. They are also known as plugs. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

20.

Debt can be used as a plug item in financial planning. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

21.

Financial models identify the best financing plan. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

22.

The decision to acquire fixed assets is unrelated to the current level of excess capacity. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

23.

Financial planning models routinely adjust for present value and risk. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

24.

If factories are operating below full capacity, sales can increase without investment in fixed assets. However, beyond some sales level, new capacity must be added and additional investment in fixed assets must be made. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

25.

A financial planning model will generally include all of the following except the: A. listing of the firm's goals. B. required increase in fixed assets. C. projected sales. D. forecast increase in retained earnings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

26.

Planners often recommend entering a market for "strategic" reasons because the: A. company is facing too much competition in its original market. B. company may have valuable follow-on investments in the new market. C. immediate investment has a positive net present value. D. manager has a personal interest in a particular market. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

27.

Which one of the following is not typically included among the three major components of a financial planning model? A. Inputs: current financial statements, forecasts of key variables B. Planning model: equations specifying key relationships C. Outputs: pro formas, financial ratios, sources and uses of cash D. Shareholders’ risk preferences AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

28.

Which one of the following is not a reason for compiling financial plans? A. Considering options B. Contingency planning C. Calculating the optimal plan D. Forcing consistency AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

29.

Calculate the rate at which a firm can grow without changing its leverage if its payout ratio is 70%, equity outstanding at the beginning of the year is $940,000, and its net income for the year is $162,000. A. 5.17% B. 11.67% C. 14.00% D. 16.67% Sustainable growth rate = (1 − 0.70) × ($162,000 / $940,000) = 0.0517, or 5.17%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

30.

The firm's current financial statements would be included in: A. the inputs of a financial plan. B. the planning model for the financial plan. C. the outputs of the financial plan. D. no part of the financial plan. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

31.

The implications of the forecasts from a financial plan are determined by the: A. plan inputs. B. balancing item. C. planning model. D. plowback ratio. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

32.

Pro formas refer to: A. plans developed by a certified financial planner. B. the inputs in the financial planning process. C. projected financial statements. D. deviations in results from previous financial plans. AACSB: Communication Accessibility: Keyboard Navigation

Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Pro forma statements

33.

Outputs from a financial plan would include such items as: A. sales growth forecasts. B. a percentage of sales planning model. C. a pro forma statement of sources and uses of cash. D. the firm's current financial statements. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

34.

When most of the elements of a financial plan are related to sales levels, the plan is: A. less likely to be effective. B. using sales as a plug figure. C. a percentage of sales model. D. not adjusted for inflation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

35.

A planner's percentage of sales model forecasts that sales will grow by 20% next year. If costs of goods sold are proportionate at 70% of sales, then costs of goods sold will: A. grow to 90% of sales. B. grow in dollars by 70%. C. not change in dollar amount. D. increase by 20% in dollar terms. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

36.

When a firm has no spare capacity, it: A. has no need for new employees. B. currently has no inventory available for sale. C. must issue new equity to grow. D. must usually increase fixed assets to increase sales. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

37.

If the pro forma balance sheet shows that total assets must increase by $400,000 while retaining a debt-equity ratio of 0.75 then: A. debt must increase by $300,000. B. equity must increase by the full $400,000. C. debt must increase by $171,429. D. equity must increase by $100,000. Increase in debt = $400,000 × 0.75 / (0.75 + 1) = $171,429

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: External financing need

38.

If sales growth for XYZ Corporation exceeds 6%, XYZ will need to seek external financing. This means that 6% is the: A. external growth rate. B. internal growth rate. C. optimal growth rate. D. sustainable growth rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

39.

If a firm's dividend payout ratio is determined after achieving a specific capital structure, then: A. dividends are an input to the financial plan. B. the capital budget should be revised. C. dividends are being used as a plug item. D. dividend forecasts become crucial to planning. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

40.

A firm has $4 million in total assets and $2.2 million in equity. How much of its $500,000 capital budget should be debtfinanced to retain the same debt-equity ratio? A. $50,000 B. $225,000 C. $275,000 D. $450,000 New debt = $500,000 × ($4m − 2.2) / $4m = $225,000

41.

If a firm uses external financing as a plug item, has a new capital budget of $2 million, a net income of $3 million, and a plowback ratio of 40%, how much should be raised in external funds? A. $200,000 B. $600,000 C. $800,000 D. $1,200,000 EFN = $2m − ($3m × 0.40) = $800,000

42.

A potential downside to using dividends as the plug item is that: A. changes in dividends may send shareholders mixed signals. B. the plan may suggest negative dividends. C. the firm may have to borrow cash to pay dividends. D. shareholders may receive an excessive return. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

43.

A firm that wants to increase its sustainable growth rate can do so by __________ the __________ ratio or by __________ the __________, or both. A. increasing; payout; increasing; ROE B. increasing; plowback; increasing; ROE C. decreasing; plowback; increasing; ROE D. decreasing; payout; decreasing; ROE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

44.

Alternative "what if?" scenarios can be easily accommodated in financial planning by use of: A. sustainable growth models. B. planning outputs. C. spreadsheet programs. D. bond covenants. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

45.

A firm currently has sales of $382,000 and net working capital of $45,840. Assume net working capital changes in direct proportion to sales. What will be the increase in net working capital if sales increase by 8%? A. $1,222 B. $2,809 C. $3,091 D. $3,667 ΔNWC = 0.08 × $45,840 = $3,667

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

46.

The observation that additions to fixed assets are lumpier than additions to current assets indicates that: A. fixed assets depreciate over time. B. fixed assets can be acquired only through external funding. C. current assets can be acquired in smaller increments. D. dollar for dollar, fixed assets are more expensive than current assets. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

47.

A firm can achieve a higher growth rate without raising external capital if it: A. has a high dividend payout ratio. B. has a low ROE. C. has a low debt-to-asset ratio. D. has a low profit margin. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

48.

Other things equal, a firm can grow more rapidly without raising new capital if: A. it has a low ROE. B. it has a high ratio of debt to assets. C. it has a low profit margin. D. it pays out a small proportion of earnings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

49.

If a firm with an asset base of $3 million recently added $150,000 to retained earnings after a dividend payment of $100,000, then its internal growth rate is: A. 1.67%. B. 3.33%. C. 5.00%. D. 8.33%. IG = $150,000 / $3 million = 0.05, or 5%

50.

What is the maximum internal growth rate for a firm reporting net income of $500,000, a dividend payout ratio of 40%, and total assets of $10 million? A. 2% B. 3% C. 5% D. 6% IG = (1 − 0.40)($500,000 / $10m) = 0.03, or 3%

51.

A firm plans to grow at 6% a year without increasing financial leverage. It expects to earn a 10% return on equity. What proportion of earnings should it plan to pay out? A. 0.40 B. 0.60 C. 0.67 D. 0.00 SG = 0.06 = 0.10 × (1 − payout ratio)

52.

A firm has an ROE of 15% and a debt-equity ratio of 40%. If it wishes to grow by 9% a year without external financing, what is the maximum proportion of earnings that it can pay out? A. 1% B. 10% C. 12% D. 16% IG = 0.09 = (1 − Payout) × 0.15 × 1 / (1 + 0.40); Payout = 0.16, or 16%

53.

Which one of the following will reduce the internal growth rate, other things equal? A. A higher plowback ratio B. A higher debt-to-asset ratio C. A higher return on equity D. A higher return on assets AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

54.

What is the sustainable growth rate for a firm with net income of $2.5 million, cash dividends of $1.5 million, and return on equity of 18%? A. 3.0% B. 5.4% C. 7.2% D. 10.8% SG = [($2.5m − 1.5) / $2.5] × 0.18 = 0.072, or 7.2%

55.

The sustainable rate of growth assumes that the: A. debt-equity ratio is held constant. B. market to book ratio increases. C. dividend payout ratio decreases. D. external debt remains constant. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

56.

A firm has a policy of not issuing debt and paying out 40% of its earnings. Its asset turnover is 2.0 and its profit margin is 10%. What is its sustainable growth rate? A. 20.0% B. 8.0% C. 3.0% D. 12.0% SG = (1 − 0.4) × 2.0 × 0.10 = 0.12

57.

A firm has sales of $1.2 million, a profit margin of 5%, and a dividend payout ratio of 25%. How much will be added to retained earnings next year if sales increase by 6%? A. $15,900 B. $21,600 C. $47,700 D. $42,000 Add to RE = ($1.2m × 1.06) × 0.05 × (1 − 0.25) = $47,700

58.

Short-term financial rarely look beyond: A. 1 year. B. 1 month. C. 1 week. D. 1 day. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Short-term finance and planning

59.

If the projected growth rate is less than the firm's sustainable growth rate: A. it should increase its projected growth rate. B. the firm will be required to decrease its plowback ratio. C. its debt-equity ratio will decrease. D. the firm will be required to increase borrowing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

60.

Contingency planning is: A. forecasting the most likely outcomes. B. working through the implications of the most likely outcomes. C. working through the consequences of the plan under different scenarios. D. formulating responses to inevitable surprises. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

61.

A major difference between financial planning and forecasting is that financial planning: A. is forward-looking. B. relies on the preferences of management. C. determines the rate of profitability. D. is equally concerned with less likely outcomes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

62.

A firm has current sales of $2.4 million and fixed assets of $1.65 million. The firm is currently operating at 88% of capacity. How high can the firm's sales go without requiring any additional fixed assets? A. $2.423 million B. $2.509 million C. $2.727 million D. $2.836 million Max sales = $2.4m / 0.88 = $2.727m

AACSB: Analytical Thinking Accessibility: Keyboard Navigation

Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

63.

The flexibility of financial plans is evident in the extent that: A. actual profits will deviate from projected profits. B. the plans can be adapted when conditions change. C. use of the plans can be extended. D. planning output is the same regardless of economic conditions. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

64.

Dawson Metals is currently operating at 94% of its capacity and has sales of $3.1 million and fixed assets of $2.5 million. How much should the firm budget for fixed asset purchases if sales are projected to increase by 9% next year? A. $0 B. $61,500 C. $43,616 D. $98,407 Sales from current capacity = $3.1m / 0.94 = $3.298m Sales forecast = $3.1m × 1.09 = $3.379m Fixed assets needed = (3.379 / 3.298) × $2.5m = $2.5615m

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

65.

The outputs of a financial planning model often include: A. the firm's current financial statements. B. a range of macroeconomic forecasts. C. the number of employees required. D. projected financial statements of the firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model.

Topic: Financial planning models

66.

Planners have determined that sales will increase by 20% next year, and the profit margin will remain at 10% of sales. Which one of the following statements is correct if the payout ratio remains at 30%? A. Net income will increase by 10% next year. B. The addition to retained earnings will increase by 20% next year. C. The dividend will increase by 6% next year. D. The addition to retained earnings will equal 6% of the sales increase next year. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

67.

A percentage-of-sales model forecasts that cost of goods sold will remain at 80% of sales. If sales revenues are expected to grow by 20% next year, cost of goods sold: A. will grow by 16%. B. will grow by 20%. C. could grow either faster or slower than sales. D. will remain constant. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

68.

A firm's goal is to maintain a 75% debt-equity ratio. How much equity would be required if the results of a financial planning model indicate that the firm's assets will grow to $4 million? A. $1.00 million B. $1.71 million C. $2.29 million D. $3.00 million Equity = [1 / (1 + 0.75)] × $4m = $2.29m

69.

If a firm commits to a dividend payment and the amount of debt that it is prepared to issue, what must be the balancing item? A. the profit margin. B. new equity issues. C. cost of goods sold. D. return on equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

70.

The final variable to have its value determined in a financial plan is often referred to as the: A. net income. B. balancing item. C. retained earnings plowback. D. growth forecast. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

71.

Which one of the following is most apt to occur if a financial plan shows sources of funds to be $100,000 and uses of funds to be $90,000? A. External debt of $10,000 will need to be raised. B. Dividend payments will be decreased by $10,000. C. Cash balances will be increased by $10,000. D. The capital budget will be decreased by $10,000. Increase in cash = $100,000 − 90,000 = $10,000

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Sources and uses of cash

72.

Increased needs for net working capital are: A. recognized in pro forma balance sheets. B. totally absorbed by retained earnings. C. typically financed with short-term debt. D. ignored due to their great variability. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

73.

How much is required in external financing if first-stage pro forma statements indicate $1 million in net income, $300,000 in dividends, and a $900,000 increase in total assets? A. $200,000 B. $500,000 C. $600,000 D. No external financing is required. External financing need = $900,000 − ($1m − 300,000) = $200,000

74.

If a firm's pro forma statements project a net income of $5,000, dividends of $2,000, and an external financing requirement of $2,000, then: A. The firm must issue new equity. B. The profit margin has declined. C. Total assets need to grow by $5,000. D. The internal growth rate is 15%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

75.

The first step in constructing a financial planning model is to: A. determine the mix of securities that the company will need to issue. B. determine the amount of external financing that is needed. C. determine what additional fixed assets the company will need. D. project future cash flows from operations. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

76.

The rate at which the assets of a firm can grow without the requirement of any external sources of financing is the: A. internal growth rate. B. sustainable growth rate. C. pro forma growth rate. D. plowback rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

77.

Which one of the following statements is correct concerning the internal growth rate? A. It is maximized when the payout ratio equals zero. B. It is maximized when the plowback ratio equals zero. C. It cannot be less than the sustainable growth rate. D. It decreases as total assets decrease. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

78.

Which one of the following changes will decrease a firm's internal growth rate? A. A decrease in dividends with a given net income B. An increase in net income with a given dividend payout ratio C. A decrease in the plowback ratio D. A decrease in assets with a set dividend payout ratio AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

79.

Under which one of the following capital structures will a firm's internal growth rate exceed its sustainable growth rate? A. Total debt-to-asset ratio equals 35%. B. Equity-to-debt ratio equals 60%. C. Equity-to-debt ratio equals 125%. D. None of the options. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

80.

What would help a firm boost its internal growth rate? A. Plowing back a low proportion of its earnings B. Achieving a high return on equity C. Decreasing reinvested earnings D. Maintaining a low sales-to-total assets ratio AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

81.

The sustainable growth rate is the maximum growth rate that the firm can achieve A. without external financing. B. while maintaining its debt ratio. C. without investing in additional fixed assets. D. without excessive strains on management. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

82.

The sustainable growth rate: A. increases as ROE decreases. B. increases as the payout ratio decreases. C. is maximized when the plowback ratio equals zero. D. cannot be greater than the internal growth rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

83.

What is the sustainable growth rate for a firm with $250,000 in net income, $100,000 in common stock dividends, and equity of $1 million? A. 8% B. 10% C. 15% D. 17% SG = [($250,000 − 100,000) / $250,000] × $250,000 / $1m = 0.15, or 15%

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

84.

What is the internal growth rate for a firm with an ROE of 20%, a dividend payout ratio of 40%, and an equity-to-debt ratio of 60%? A. 4.50% B. 5.39% C. 8.00% D. 12.00% IG = (1 − 0.40) × 0.20 × [0.60 / (1 + 0.60)] = 0.0450, or 4.50%

85.

Which one of the following would increase the sustainable growth rate? A. Reduce the ROE. B. Increase the asset beta. C. Reduce the payout ratio. D. Reduce the operating leverage. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

86.

All of the following are part of the financial planning process except: A. deciding which risks are worth taking. B. analyzing investment and financing options. C. projecting the future. D. minimizing risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

87.

Which one of these is least likely to change proportionally with sales? A. Depreciation B. Investment in receivables C. Cost of goods sold D. EBIT AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

88.

A firm's internal growth rate is all of the following except: A. the rate below which external financing is needed. B. the ratio of reinvested earnings to assets. C. the maximum growth rate without requiring external sources of new capital. D. the product of the plowback ratio, ROE, and the ratio of equity to assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-03 Estimate the effect of growth on the need for external financing. Topic: Internal and sustainable growth rates

89.

A financial plan: A. is generally considered to be a useless exercise due to unforeseen events. B. should include all possible contingencies. C. provides a basis for evaluating future performance. D. should always be based on the worst-case scenario. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

90.

In the percentage of sales model, which one of these is most likely to increase in uneven increments as sales increase? A. Cost of raw materials B. Accounts receivable C. Accounts payable D. Fixed assets AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

91.

Which one of these best describes the relationship between net working capital (NWC) and sales? A. NWC will change by the same percentage as sales. B. NWC is unaffected by changes in the sales level. C. NWC changes by a greater percentage than the change in sales, but the change is linear in nature. D. NWC changes in direct relation to sales, but the change may be less than proportional with sales. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

92.

A percentage of sales model projects sales to increase by 5% annually over the next 4 years. If costs are forecast at a constant 80% of sales, and this year's income is $1,250, the forecast income in the fourth year will be: A. $1,447.03. B. $1,826.15. C. $1,595.35. D. $1,519.38. Net incomeYear 4 = $1,250 × (1 + 0.05)4 = $1,519.38

93.

If a firm's sales increase by 12%, and it has no spare capacity, it must increase fixed assets by at least: A. 0%. B. 6%. C. 9%. D. 12%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning models

94.

If book equity increases by $2,000, the firm does not issue new equity, and its net income is $2,500, then: A. the firm paid a dividend of $500. B. the firm plowed $500 back into the company. C. $500 went into retained earnings. D. debt increased by $2,000. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

95.

Sources and uses of funds are made equal through: A. a balancing item. B. pro forma financial statements. C. borrowed cash. D. additions to retained earnings. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

96.

Which one of the following statements regarding financial planning models is false? A. The models should include as much detail as possible. B. The results of a model are pro forma financial statements. C. The plug variable maintains consistency. D. Financial analysis is not used in financial planning. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

97.

Which one of the following is not an output of a financial plan? A. Financial ratios B. Pro forma statements C. Sources and uses of cash statement D. Sales forecasts AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-01 Describe the contents and uses of a financial plan. Topic: Financial planning basics

98.

If a firm does not want to use either dividends or debt as the plug, then the obvious plug is: A. inventory B. cash C. new issue of equity D. fixed assets AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 18-02 Construct a simple financial planning model. Topic: Financial planning models

99.

A firm has projected sales of $328,000, costs of goods sold equal to 68% of sales, interest of $18,500, a tax rate of 35%, and a dividend payout ratio of 60%. What will be the addition to retained earnings? A. $16,667 B. $22,480 C. $24,002 D. $19,531 Add to RE = ({[$328,000(1 − 0.68)] − $18,500} × (1 − 0.35)) × (1 − 0.60) = $22,480

100.

Assume a firm wants to hold its current long-term debt-to-equity ratio constant at 0.55 and its payout ratio constant at 35%. The firm neither issues nor repurchases shares. If the firm generates $326,000 of net income, what is the maximum amount that the firm can increase its long-term debt? A. $116,545 B. $95,355 C. $122,615 D. $0 Maximum debt increase = $326,000 × (1 − 0.35) × 0.55 = $116,545

101.

A firm's net assets equal 55% of sales. The firm expects sales to increase of $78,000 next year and to generate $6,500 of retained earnings. What is the external financing need? A. $49,400 B. $21,200 C. $28,600 D. $36,400 EFN = 0.55 × $78,000 − $6,500 = $36,400

Chapter 18 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

101

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

101

Learning Objective: 18-01 Describe the contents and uses of a financial plan.

Learning Objective: 18-02 Construct a simple financial planning model.

Learning Objective: 18-03 Estimate the effect of growth on the need for external financing.

Topic: External financing need

Topic: Financial planning basics

Topic: Financial planning models

Topic: Internal and sustainable growth rates

Topic: Pro forma statements

Topic: Short-term finance and planning

Topic: Sources and uses of cash

Chapter 19 Test bank - Static Student: ___________________________________________________________________________

When financial managers are asked the key reason for choosing short-term rather than long-term debt, they often say that they try to match the maturities of the firm's assets and liabilities. True

False

A company that borrows $1 million short term and invests the proceeds in inventory will see its cash position unchanged. True

False

Most firms have a permanent investment in working capital. True

False

A company that pays $5,000 previously owed to one of its suppliers will see a $5,000 decrease in cash. True

False

A company that sells goods to a customer on credit will see no immediate change in its cash position. True

False

Companies with unusually high cash reserves often hold the cash in tax havens. True

False

Unlike long-term planners short-term planners are concerned only with the most likely outcomes. True

False

Firms with a permanent investment in working capital finance that investment with short-term debt. True

False

10. The term "tax inversion" refers to the negative tax shield that is created when a firm invests in securities. True

False

11. Evidence suggests that investors place a particularly high value on liquidity in the case of companies with growth opportunities. True

False

12. A company that sells $5 million of marketable securities will see a $5 million increase in cash. True

False

13. The largest inflows of cash usually come from payments by the firm’s customers. True

False

14. Unless customers pay cash on delivery, cash flow comes from collections on receivables. True

False

15. The primary aim of cash budgeting models is to obtain better forecasts of earnings. True

False

16. If a firm reduces its accounts payable period, other things equal, it increases its cash holdings. True

False

17. Firms with surplus cash can use it to increase dividends or buy back securities. True

False

18. Short-term financing plans are usually developed by trial and error. True

False

19. A reduction in inventory levels would be a source of cash. True

False

20. Cash holdings decline when a firm buys raw materials on credit. True

False

21. If a firm’s customers on average take two weeks to pay their bills, then about half of each month’s bills will not be paid until the following month. True

False

22. A firm that sells marketable securities will see an increase in its working capital but no change in its holdings of cash. True

False

23. Many high tech firms hold large amounts of marketable securities. True

False

24. Holdings of marketable securities are at worst zero-NPV investments for taxpaying firms. True

False

25. An increase in current liabilities is a source of cash for the firm. True

False

26. The short-term financial plan sets out a strategy for investing any cash surpluses or financing any deficit. True

False

27. For firms facing financial distress a dollar of cash within the firm is often worth less than a dollar to shareholders. True

False

28. Managers with a large surplus of cash are often tempted to run a less tight ship. True

False

29. If the firm repurchases its own stock, its cash holdings are unaffected. True

False

30. Investments in marketable securities are generally a positive NPV investment for tax-paying firms. True

False

31. An increase in long-term assets is a source of cash for the firm. True

False

32. An increase in accounts payable is a source of cash. True

False

33. A company stretches payables whenever it offers more generous payment terms to its customers. True

False

34. Firms with large holdings of current assets generally enjoy greater liquidity. True

False

35. Inventory is generally more liquid than receivables. True

False

36. A company that matches maturities will generally try to finance its receivables with long-term debt. True

False

37. The planning horizon for cash budgeting is usually at least five years. True

False

38. Which of the following statements is not true of short-term financial planning? A. The plan should consider possible shortfalls in sales or a delay in collections. B. The plan seeks to ensure that the company will be able to meet its cash needs. C. The planning period is typically five years. D. The plan needs to be based on the best forecasts available. 39. Which of these events reduces cash holdings? A. The firm changes its terms of sale and gives customers less time to pay for their purchases. B. The firm sells a parcel of land at a profit. C. The firm pays more promptly for its raw materials. D. The firm sells a parcel of land at a loss. 40. Which of these assets is likely to be the least liquid? A. receivables B. marketable securities C. inventories of work in progress D. inventories of finished goods 41. Brad Corp expects to make sales of $80 million in January. In February forecast sales are $90 million, and in March they are $60 million. On average 50% of sales are paid for in the current month, 30% are paid for in the next month, and the remainder in the following month. What is the expected cash flow from operations in March? A. $30 million B. $60 million C. $73 million D. $76.7 million 42. Which of the following transactions would not be a source of cash: A. The firm issues $1 million of short-term debt and invests the proceeds in inventory. B. A customer pays an outstanding bill. C. The firm sells $10 million of marketable securities. D. The firm receives $10 million from an insurance company to compensate for flood damage earlier that month. 43. A firm purchases $32 million of materials from suppliers in January, $28 million in February and $25 million in March. Forty percent are supplied cash on delivery. The remainder needs to be paid for in the following month. What is the cash outflow in February? A. $26.2 million B. $29.6 million C. $30.4 million D. $32.0 million

44.

Splitterfield Foods forecasts the following sales and expenses:

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

June 120

July 150

August 160

Seventy percent of sales are paid for in the same month and the remainder with a delay of one month. All raw materials are paid for with a of one month, other expenses are paid with no delay. What is the expected cash flow from operations in July? A. $29.5 million. B. $32 million. C. $33 million. D. $20 million. 45. A toy store does not pay for its purchases of toys from manufacturers until one month later. Suppose that in October it starts to stock up in anticipation of a surge in toy sales in December, when is it most likely to have a negative operating cash flow? A. It should never have a negative operating cash flow as long as its business is profitable. B. In October because this is when it starts to stock up. C. In November because this is when it will need to pay for the increased inventory. D. In December because this is when the toys will start to move off the shelves. 46. Which one of the following statements best describes the total capital requirement for most profitable firms? A. The general trend in the total capital requirement is downward sloping. B. The total capital requirement tends to be constant over long periods of time. C. There are seasonal fluctuations around the total capital requirement trend. D. The total capital requirement must be funded with short-term debt. 47. When a firm finances long-term assets with short-term sources of funding, it: A. reduces the risk of cash shortage. B. will generally have lower interest expense. C. improves the leverage ratio. D. violates the principle of matched maturities. 48. The principle of matched maturities in finance refers to: A. finding sources of funds with the longest maturity, in order to avoid liquidity crises. B. funding long-term assets with long-term sources and short-term assets with short-term financing. C. using as much short-term financing as possible due to the lower cost of interest. D. buying marketable securities when demand is high and borrowing short-term when demand is low.

49. Which one of the following is more likely for a firm practicing the relaxed strategy of long-versus short-term borrowing at the height of sales demand? A. It will borrow heavily on a short-term basis. B. At the height of demand, it will invest heavily in marketable securities. C. It will borrow on both a long-term and a short-term basis. D. It's long-term financing will approximately equal its total capital requirements. 50. When internally generated cash is temporarily insufficient to meet a firm’s cash need, the firm following a middle-of-the-road policy for long- versus short-term financing will: A. borrow short term. B. borrow long term. C. hold marketable securities. D. payoff all debts. 51. A firm's permanent working capital refers to the: A. difference between fixed assets and current assets. B. maximum difference between current assets and current liabilities. C. portion of net working capital that is financed from long-term sources. D. amounts that must be held to meet debt covenants. 52. Firms that continually invest in nontrivial amounts of marketable securities may be guilty of: A. excessive short-term borrowing. B. not matching their sources and uses of cash. C. holding excessive current liabilities. D. incurring extra taxes. 53. What happens to a firm whose uses of cash exceed its sources of cash during an accounting period? A. It has a loss of net working capital. B. It declares a net loss on the income statement. C. It experiences a decrease in sales. D. It experiences a decrease in its cash balance. 54. Which one of the following would not be considered a use of cash? A. Dividends B. Decreased accounts payable C. Depreciation D. Increased accounts receivable 55. Avatar Corp solves its cash shortage by paying its bills a week late but loses a 1% discount by doing so. This is equivalent to borrowing at an annual interest rate of: A. 52.0%. B. 12.8%. C. 68.6%. D. 1.0%.

56. A firm starts with $5,000 of accounts receivables and ends the period with $4,000 of receivables. If it collected $4,000 of receivables during the period, what was the amount of sales? A. $19,000 B. $20,000 C. $21,000 D. $24,000 57. A firm had $2,800 cash at the beginning of the period. During the period, the firm collected $1,600 in receivables, paid $1,850 to supplier, had credit sales of $4,200, and incurred cash expenses of $2,300. What was the cash balance at the end of the period? A. $4,450 B. $250 C. $2,850 D. $1,250 58. Which one of the following is least likely to be correct for a firm that repeatedly stretches its payables? A. The firm may receive more favorable status from suppliers. B. The firm may reduce its explicit short-term interest expense. C. The cost of forgone discounts may exceed the cost of bank credit. D. The firm may be labeled as a credit risk. 59. A firm must decide between borrowing from a bank at 12% interest or stretching its payables for one quarter. If it stretches the payables it will forgo a 2% discount for timely payment. Based solely on cash flows, which is the cheaper solution? A. Stretching saves the firm approximately 8% per year. B. Use the bank loan; forgoing a cash discount is costly. C. Stretch the payables and finance at a savings of approximately 3.75% annually. D. Use the bank loan because it represents simple interest. 60. A firm starts the week with payables of $172,000. It pays $80,000 of outstanding bills, and purchases $44,000 of raw materials on one month’s credit. What is the level of payables at the end of the week? A. $136,000. B. $208,000. C. $96,000. D. $216,000. 61. A firm starts the week with payables of $172,000, it pays $$80,000 of outstanding bills, and purchases $44,000 of raw materials on one month’s credit. What is the change in its cash balance over the week? A. −$36,000 B. +$96,000 C. −$80,000 D. +$92,000

62. Which of the following will not reduce an imminent cash shortage? A. Phoning customers who have overdue bills. B. Issuing common stock to repay long-term debt. C. Postponing purchase of a new machine. D. Rolling over maturing bank debt. 63. Zeta Stores places orders for 60% of the sales forecast in the next month and for 40% of the sales forecast for the following month. It pays for these goods with a 2-month delay. If sales for August are forecast at $10 million and sales for September and October are forecast at $12 million, what will be the forecast cash outflow in September? A. $10.8 million. B. $15.6 million. C. $4.8 million. D. $9.6 million. 64. Zeta Stores places orders for 60% of the sales forecast in the next month and for 40% of the sales forecast for the following month. It pays for these goods with a 1-month delay? If sales for August are forecast at $10 million and sales for September and October are forecast at $12 million, what will be the forecast cash outflow in September? A. $10.8 million B. $15.6 million C. $4.8 million D. $9.6 million 65. A firm that stretches its payables gains an extra 1 month before it needs to pay for its purchases of raw materials but it loses a 2% discount for prompt payment. This is like borrowing at an effective annual interest rate of: A. 19.40% B. 24.00% C. 26.53% D. 27.43% 66. Which statement does not correctly describe short-term financial decisions? A. Most firms finance short-term assets with short-term borrowing. B. Most firms maintain a positive investment in working capital. C. Most firms finance their investment in working capital with short-term debt. D. Liquidity is particularly valued by small firms that face relatively high costs to raising funds on short notice. 67. There are three steps to constructing a cash budget. Which of the following is not one of those steps? A. Calculate whether the firm is facing a cash shortage or surplus. B. Forecast the uses of cash. C. Set a policy for deciding how much time to give customers to pay. D. Forecast the sources of cash.

68. Before settling on a final short-term financial plan, the manager needs to ask several questions. Which is the odd man out? A. Does the plan yield satisfactory financial ratios? B. Would the firm do better to arrange long-term financing to cover any cash shortage? C. Has the firm estimated its EVA correctly? D. Does the company need a larger reserve of cash or marketable securities to cover emergencies? 69. Clopton Inc. forecasts cash sales of $18 million in January, $23 million in February and $25 million in March. Credit sales in these three months are forecast at $80 million, $110 million and $145 million. On average 50% of credit sales are paid for in the current month, 30% in the next month, and the remainder in the following month. What is the expected cash inflow in March? A. $121.5 million B. $102 million C. $127 million D. $146.5 million 70. When managers are continually short-term lenders, they are said to follow a: A. middle-of-the-road financing strategy. B. restrictive financing strategy. C. relaxed financing strategy. D. permanent working-capital strategy. 71. When the length of the financing is directly related to the life of the asset being financed, the firm is said to follow a: A. policy of maturity matching. B. restrictive financing strategy. C. matched depreciation strategy. D. minimum working capital strategy. 72. Which one of these is most associated with a disadvantage of the relaxed strategy of long- versus short-term financing? A. Transaction costs are required to continually obtain financing. B. Short-term investment income is often unattractive. C. Investment opportunities must frequently be ignored. D. Long-term financing has burdensome tax consequences. 73. Which one of the following is a use of cash? A. Net income B. Repayment of a bank loan C. Reduction in accounts receivable D. Depreciation 74. Which of the following would increase the firm’s cash balance? A. increase the cash dividend B. increase the accounts payable C. increase accounts receivable D. increase inventory

75. Managers are alerted to projected cash shortages by means of the: A. statement of sources and uses of cash. B. pro forma balance sheet. C. cash budget. D. monthly bank statements. 76. In the preparation of cash budgets, capital expenditures are: A. not included because these items are depreciated. B. included as sources of operating cash. C. included as uses of cash and make the budget lumpy. D. traditionally offset as a use of cash by interest income. 77. Managers who "stretch their payables" are attempting to: A. repay more recent bills before earlier bills. B. improve their current ratio before preparing financial statements. C. offer finished goods at a discount for quicker repayment. D. obtain short-term financing. 78. Which one of the following would not be included as a source of short-term financing? A. Line of credit from a bank B. Increase in the minimum operating cash balance C. Sale of marketable securities D. Stretching of accounts payable 79. For a recent period, a firm collected $38,200 on accounts receivable, paid $19,700 to suppliers on trade credit, paid $12,000 in cash expenses, purchased for cash a $42,000 piece of equipment that will be depreciated straight-line to zero over 4 years, and had $59,000 of sales of which 15% were cash sales. The firm also paid $13,500 in taxes and interest. The beginning cash balance was $11,300. How much did the firm need to borrow in order to maintain a minimum cash balance of $10,000? A. $38,850 B. $37,550 C. $7,350 D. $30,000 80. The Boat Works started the month with $1.28 million in accounts receivable. Sales for the month were $3.4 million. The firm collects 35% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A. $2.21 million B. $1.19 million C. $3.49 million D. $2.71 million

81. The Boat Works started the month with $3.21 million in accounts receivable. Sales for the month were $7.84 million. The firm collects 18% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A. $4,621,200 B. $6,428,800 C. $9,061,000 D. $1,411,200 82. A firm that follows a relaxed strategy toward the total capital requirement will be a: A. short-term borrower. B. short-term lender. C. long-term lender. D. long-term borrower. 83. Issuing additional long-term debt of $5 million and buying new long-term assets worth $4 million and short-term assets of $1 million will result in a net cash flow of: A. $5 million B. $9 million C. $0 million D. $4 million 84. A firm has $50 million and $60 million credit sales during the first two quarters of the year. Eighty percent of the receivables are collected in the same quarter and the balance in the next quarter. What will be the total collection for the firm in the second quarter? A. $55 million B. $58 million C. $88 million D. $98 million

Chapter 19 Test bank - Static Key 1.

When financial managers are asked the key reason for choosing short-term rather than long-term debt, they often say that they try to match the maturities of the firm's assets and liabilities. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

Biotech firms require large amounts of cash if their drugs succeed in gaining regulatory approval. Therefore, these firms often have substantial cash holdings to fund their possible investment needs. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

Unlike long-term planners short-term planners are concerned only with the most likely outcomes. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

Companies with unusually high cash reserves often hold the cash in tax havens. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

A company that sells goods to a customer on credit will see no immediate change in its cash position. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

A company that pays $5,000 previously owed to one of its suppliers will see a $5,000 decrease in cash. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

Most firms have a permanent investment in working capital. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

A company that borrows $1 million short term and invests the proceeds in inventory will see its cash position unchanged. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

Firms with a permanent investment in working capital finance that investment with short-term debt. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

10.

The term "tax inversion" refers to the negative tax shield that is created when a firm invests in securities. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic

Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

11.

Evidence suggests that investors place a particularly high value on liquidity in the case of companies with growth opportunities. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

12.

A company that sells $5 million of marketable securities will see a $5 million increase in cash. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

13.

The largest inflows of cash usually come from payments by the firm’s customers. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Preparing the cash budget

14.

Unless customers pay cash on delivery, cash flow comes from collections on receivables. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Preparing the cash budget

15.

The primary aim of cash budgeting models is to obtain better forecasts of earnings. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash.

Topic: Preparing the cash budget

16.

If a firm reduces its accounts payable period, other things equal, it increases its cash holdings. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

17.

Firms with surplus cash can use it to increase dividends or buy back securities. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

18.

Short-term financing plans are usually developed by trial and error. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

19.

A reduction in inventory levels would be a source of cash. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

20.

Cash holdings decline when a firm buys raw materials on credit. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

21.

If a firm’s customers on average take two weeks to pay their bills, then about half of each month’s bills will not be paid until the following month. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

22.

A firm that sells marketable securities will see an increase in its working capital but no change in its holdings of cash. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

23.

Many high tech firms hold large amounts of marketable securities. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

24.

Holdings of marketable securities are at worst zero-NPV investments for taxpaying firms. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial policy

25.

An increase in current liabilities is a source of cash for the firm. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

26.

The short-term financial plan sets out a strategy for investing any cash surpluses or financing any deficit. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

27.

For firms facing financial distress a dollar of cash within the firm is often worth less than a dollar to shareholders. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

28.

Managers with a large surplus of cash are often tempted to run a less tight ship. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

29.

If the firm repurchases its own stock, its cash holdings are unaffected. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

30.

Investments in marketable securities are generally a positive NPV investment for tax-paying firms. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

31.

An increase in long-term assets is a source of cash for the firm. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

32.

An increase in accounts payable is a source of cash. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

33.

A company stretches payables whenever it offers more generous payment terms to its customers. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

34.

Firms with large holdings of current assets generally enjoy greater liquidity. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

35.

Inventory is generally more liquid than receivables. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

36.

A company that matches maturities will generally try to finance its receivables with long-term debt. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial policy

37.

The planning horizon for cash budgeting is usually at least five years. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Preparing the cash budget

38.

Which of the following statements is not true of short-term financial planning? A. The plan should consider possible shortfalls in sales or a delay in collections. B. The plan seeks to ensure that the company will be able to meet its cash needs. C. The planning period is typically five years. D. The plan needs to be based on the best forecasts available. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

39.

Which of these events reduces cash holdings?

A. The firm changes its terms of sale and gives customers less time to pay for their purchases. B. The firm sells a parcel of land at a profit. C. The firm pays more promptly for its raw materials. D. The firm sells a parcel of land at a loss. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

40.

Which of these assets is likely to be the least liquid?

A. receivables B. marketable securities C. inventories of work in progress D. inventories of finished goods AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

41.

Brad Corp expects to make sales of $80 million in January. In February forecast sales are $90 million, and in March they are $60 million. On average 50% of sales are paid for in the current month, 30% are paid for in the next month, and the remainder in the following month. What is the expected cash flow from operations in March?

A. $30 million B. $60 million C. $73 million D. $76.7 million Cash flow = (0.5 × 60) + (0.3 × 90) + (0.2 × 80) = $73 million

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

42.

Which of the following transactions would not be a source of cash:

A. The firm issues $1 million of short-term debt and invests the proceeds in inventory. B. A customer pays an outstanding bill. C. The firm sells $10 million of marketable securities. D. The firm receives $10 million from an insurance company to compensate for flood damage earlier that month. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

43.

A firm purchases $32 million of materials from suppliers in January, $28 million in February and $25 million in March. Forty percent are supplied cash on delivery. The remainder needs to be paid for in the following month. What is the cash outflow in February?

A. $26.2 million B. $29.6 million C. $30.4 million D. $32.0 million CF = (0.4 × 28) + (0.6 × 32) = $30.4 million

44. Splitterfield Foods forecasts the following sales and expenses:

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

June 120

July 150

August 160

Seventy percent of sales are paid for in the same month and the remainder with a delay of one month. All raw materials are paid for with a delay of one month, other expenses are paid with no delay. What is the expected cash flow from operations in July? A. $29.5 million. B. $32 million. C. $33 million. D. $20 million. CF = (0.7 × 150 + 0.3 × 120) − 70 − 38 = $33 million

45.

A toy store does not pay for its purchases of toys from manufacturers until one month later. Suppose that in October it starts to stock up in anticipation of a surge in toy sales in December, when is it most likely to have a negative operating cash flow? A. It should never have a negative operating cash flow as long as its business is profitable. B. In October because this is when it starts to stock up. C. In November because this is when it will need to pay for the increased inventory. D. In December because this is when the toys will start to move off the shelves. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

46.

Which one of the following statements best describes the total capital requirement for most profitable firms? A. The general trend in the total capital requirement is downward sloping. B. The total capital requirement tends to be constant over long periods of time. C. There are seasonal fluctuations around the total capital requirement trend. D. The total capital requirement must be funded with short-term debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

47.

When a firm finances long-term assets with short-term sources of funding, it: A. reduces the risk of cash shortage. B. will generally have lower interest expense. C. improves the leverage ratio. D. violates the principle of matched maturities. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

48.

The principle of matched maturities in finance refers to: A. finding sources of funds with the longest maturity, in order to avoid liquidity crises. B. funding long-term assets with long-term sources and short-term assets with short-term financing. C. using as much short-term financing as possible due to the lower cost of interest. D. buying marketable securities when demand is high and borrowing short-term when demand is low. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic

Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

49.

Which one of the following is more likely for a firm practicing the relaxed strategy of long-versus short-term borrowing at the height of sales demand? A. It will borrow heavily on a short-term basis. B. At the height of demand, it will invest heavily in marketable securities. C. It will borrow on both a long-term and a short-term basis. D. It's long-term financing will approximately equal its total capital requirements. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

50.

When internally generated cash is temporarily insufficient to meet a firm’s cash need, the firm following a middle-of-theroad policy for long- versus short-term financing will: A. borrow short term. B. borrow long term. C. hold marketable securities. D. payoff all debts. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

51.

A firm's permanent working capital refers to the: A. difference between fixed assets and current assets. B. maximum difference between current assets and current liabilities. C. portion of net working capital that is financed from long-term sources. D. amounts that must be held to meet debt covenants. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

52.

Firms that continually invest in nontrivial amounts of marketable securities may be guilty of: A. excessive short-term borrowing. B. not matching their sources and uses of cash. C. holding excessive current liabilities. D. incurring extra taxes. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

53.

What happens to a firm whose uses of cash exceed its sources of cash during an accounting period? A. It has a loss of net working capital. B. It declares a net loss on the income statement. C. It experiences a decrease in sales. D. It experiences a decrease in its cash balance. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

54.

Which one of the following would not be considered a use of cash? A. Dividends B. Decreased accounts payable C. Depreciation D. Increased accounts receivable AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

55.

Avatar Corp solves its cash shortage by paying its bills a week late but loses a 1% discount by doing so. This is equivalent to borrowing at an annual interest rate of: A. 52.0%. B. 12.8%. C. 68.6%. D. 1.0%. Annual Interest Rate = 1 / (0.99) ^ 52 = 68.6%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

56.

A firm starts with $5,000 of accounts receivables and ends the period with $4,000 of receivables. If it collected $4,000 of receivables during the period, what was the amount of sales? A. $19,000 B. $20,000 C. $21,000 D. $24,000 Sales = $4,000 − 5,000 + 20,000 = $19,000

57.

A firm had $2,800 cash at the beginning of the period. During the period, the firm collected $1,600 in receivables, paid $1,850 to supplier, had credit sales of $4,200, and incurred cash expenses of $2,300. What was the cash balance at the end of the period? A. $4,450 B. $250 C. $2,850 D. $1,250 Ending cash − $2,800 + 1,600 − 1,850 − 2,300 = $250

58.

Which one of the following is least likely to be correct for a firm that repeatedly stretches its payables? A. The firm may receive more favorable status from suppliers. B. The firm may reduce its explicit short-term interest expense. C. The cost of forgone discounts may exceed the cost of bank credit. D. The firm may be labeled as a credit risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

59.

A firm must decide between borrowing from a bank at 12% interest or stretching its payables for one quarter. If it stretches the payables it will forgo a 2% discount for timely payment. Based solely on cash flows, which is the cheaper solution? A. Stretching saves the firm approximately 8% per year. B. Use the bank loan; forgoing a cash discount is costly. C. Stretch the payables and finance at a savings of approximately 3.75% annually. D. Use the bank loan because it represents simple interest. Annual cost of foregone discount = 1.024 − 1 = 8.24%

60.

A firm starts the week with payables of $172,000. It pays $80,000 of outstanding bills, and purchases $44,000 of raw materials on one month’s credit. What is the level of payables at the end of the week? A. $136,000. B. $208,000. C. $96,000. D. $216,000. $172,000 − $80,000 + $44,000 = $136,000

61.

A firm starts the week with payables of $172,000, it pays $$80,000 of outstanding bills, and purchases $44,000 of raw materials on one month’s credit. What is the change in its cash balance over the week? A. −$36,000 B. +$96,000 C. −$80,000 D. +$92,000 AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

62.

Which of the following will not reduce an imminent cash shortage? A. Phoning customers who have overdue bills. B. Issuing common stock to repay long-term debt. C. Postponing purchase of a new machine. D. Rolling over maturing bank debt. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

63.

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

64.

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

65.

A firm that stretches its payables gains an extra 1 month before it needs to pay for its purchases of raw materials but it loses a 2% discount for prompt payment. This is like borrowing at an effective annual interest rate of: A. 19.40% B. 24.00% C. 26.53% D. 27.43% EAR = [1 + (($100 − 98) / $98)]12 − 1 = 0.2743, or 27.43%

66.

Which statement does not correctly describe short-term financial decisions? A. Most firms finance short-term assets with short-term borrowing. B. Most firms maintain a positive investment in working capital. C. Most firms finance their investment in working capital with short-term debt. D. Liquidity is particularly valued by small firms that face relatively high costs to raising funds on short notice. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

67.

There are three steps to constructing a cash budget. Which of the following is not one of those steps? A. Calculate whether the firm is facing a cash shortage or surplus. B. Forecast the uses of cash. C. Set a policy for deciding how much time to give customers to pay. D. Forecast the sources of cash. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Preparing the cash budget

68.

Before settling on a final short-term financial plan, the manager needs to ask several questions. Which is the odd man out? A. Does the plan yield satisfactory financial ratios? B. Would the firm do better to arrange long-term financing to cover any cash shortage? C. Has the firm estimated its EVA correctly? D. Does the company need a larger reserve of cash or marketable securities to cover emergencies? AACSB: Communication Accessibility: Keyboard Navigation

Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial plan

69.

Clopton Inc. forecasts cash sales of $18 million in January, $23 million in February and $25 million in March. Credit sales in these three months are forecast at $80 million, $110 million and $145 million. On average 50% of credit sales are paid for in the current month, 30% in the next month, and the remainder in the following month. What is the expected cash inflow in March? A. $121.5 million B. $102 million C. $127 million D. $146.5 million CF = 25 + (0.5 × 145) + (0.3 × 110) + (0.2 × 80) = $146.5 million

70.

When managers are continually short-term lenders, they are said to follow a: A. middle-of-the-road financing strategy. B. restrictive financing strategy. C. relaxed financing strategy. D. permanent working-capital strategy. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

71.

When the length of the financing is directly related to the life of the asset being financed, the firm is said to follow a: A. policy of maturity matching. B. restrictive financing strategy. C. matched depreciation strategy. D. minimum working capital strategy. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

72.

Which one of these is most associated with a disadvantage of the relaxed strategy of long- versus short-term financing? A. Transaction costs are required to continually obtain financing. B. Short-term investment income is often unattractive. C. Investment opportunities must frequently be ignored. D. Long-term financing has burdensome tax consequences. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

73.

Which one of the following is a use of cash? A. Net income B. Repayment of a bank loan C. Reduction in accounts receivable D. Depreciation AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

74.

Which of the following would increase the firm’s cash balance? A. increase the cash dividend B. increase the accounts payable C. increase accounts receivable D. increase inventory AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

75.

Managers are alerted to projected cash shortages by means of the: A. statement of sources and uses of cash. B. pro forma balance sheet. C. cash budget. D. monthly bank statements. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

76.

In the preparation of cash budgets, capital expenditures are: A. not included because these items are depreciated. B. included as sources of operating cash. C. included as uses of cash and make the budget lumpy. D. traditionally offset as a use of cash by interest income. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

77.

Managers who "stretch their payables" are attempting to: A. repay more recent bills before earlier bills. B. improve their current ratio before preparing financial statements. C. offer finished goods at a discount for quicker repayment. D. obtain short-term financing. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

78.

Which one of the following would not be included as a source of short-term financing? A. Line of credit from a bank B. Increase in the minimum operating cash balance C. Sale of marketable securities D. Stretching of accounts payable AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash. Topic: Short-term financial plan

79.

For a recent period, a firm collected $38,200 on accounts receivable, paid $19,700 to suppliers on trade credit, paid $12,000 in cash expenses, purchased for cash a $42,000 piece of equipment that will be depreciated straight-line to zero over 4 years, and had $59,000 of sales of which 15% were cash sales. The firm also paid $13,500 in taxes and interest. The beginning cash balance was $11,300. How much did the firm need to borrow in order to maintain a minimum cash balance of $10,000? A. $38,850 B. $37,550 C. $7,350 D. $30,000 Cash balance = $11,300 + 38,200 − 19,700 − 12,000 − 42,000 + (0.15 × $59,000) − 13,500 − 10,000 = −$38,850; Thus, the firm needs to borrow $38,850.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Short-term financial plan

80.

The Boat Works started the month with $1.28 million in accounts receivable. Sales for the month were $3.4 million. The firm collects 35% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A. $2.21 million B. $1.19 million C. $3.49 million D. $2.71 million Ending A / R = $1.28m + 3.4m − 1.28m − (0.35 × $3.4m) = $2.21m

81.

The Boat Works started the month with $3.21 million in accounts receivable. Sales for the month were $7.84 million. The firm collects 18% of its sales in the month of sale with the remainder paid the following month. What is the accounts receivable balance at month end? A. $4,621,200 B. $6,428,800 C. $9,061,000 D. $1,411,200 Ending A / R = $3.21 + 7.84m − 3.21m − (0.18 × $7.84m) = $6,428,800

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze

Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

82.

A firm that follows a relaxed strategy toward the total capital requirement will be a: A. short-term borrower. B. short-term lender. C. long-term lender. D. long-term borrower. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements. Topic: Short-term financial policy

83.

Issuing additional long-term debt of $5 million and buying new long-term assets worth $4 million and short-term assets of $1 million will result in a net cash flow of: A. $5 million B. $9 million C. $0 million D. $4 million Issuing new long-term debt is a source of cash and buying new assets is a use of cash. So, the net cash flow is zero.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing. Topic: Sources and uses of cash

84.

A firm has $50 million and $60 million credit sales during the first two quarters of the year. Eighty percent of the receivables are collected in the same quarter and the balance in the next quarter. What will be the total collection for the firm in the second quarter? A. $55 million B. $58 million C. $88 million D. $98 million Q2 collections = (1 − 0.80) × $50m + 0.80 × $60m = $58m

Chapter 19 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 19-01 Show how long-term financing policy affects short-term financing requirements.

Learning Objective: 19-02 Trace a firm's sources and uses of cash and evaluate its need for short-term borrowing.

Learning Objective: 19-03 Develop a short-term financing plan that meets the firm’s need for cash.

Topic: Cash collections

Topic: Preparing the cash budget

Topic: Short-term financial plan

Topic: Short-term financial policy

Topic: Sources and uses of cash

Chapter 20 Test bank - Static Student: ___________________________________________________________________________

Large payments between businesses are generally made electronically through either CHIPS or Fedwire. True

Inventory makes up the bulk of the current assets of retail firms. True

False

Just-in-time inventory management seeks to reduce inventory levels. True

False

A firm that buys on credit is in effect borrowing from its supplier. True

False

The more liberal the terms of the collection policy, the lower the potential for bad debts and unprofitable sales. True

False

Firms are more likely to grant credit the higher the probability that a potential customer will become a repeat customer. True

False

Absent any possibility of repeat orders, if the default probability is less than the profit margin, you should extend credit for the sale. True

False

The potential benefits of additional credit analysis should always be weighed against the incremental costs. True

False

Commercial paper is usually used to finance overseas trade. True

False

10. Extending trade credit can increase the probability of repeat orders. True

False

11. The decision to offer credit depends on the probability of payment. You should grant credit if the expected profit from doing so is greater than the profit from refusing. True

False

12. Bond ratings are an expensive source of credit information on publicly traded companies. True

False

13. An aging schedule is a statement sent to customers who are delinquent in their payments. True

False

14. Optimal inventory levels are lower when carrying costs are high, and when the cost of restocking inventories is low. True

False

15. Since defaults can be costly, it is cost-effective to undertake a full credit analysis of all customers. True

False

16. Checks that have been mailed but not yet cleared result in float. True

False

17. Short-term securities have high interest-rate risk. True

False

18. Lock-box systems allow local banks to collect and process the firm's remittances from that area. True

False

19. As the number of inventory orders per year increases, the total order costs decrease. True

False

20. Checks tend to be a more popular method of payment in the United States than in many other developed countries. True

False

21. Most money market instruments have a high degree of liquidity. True

False

22. Repos are long-term unsecured loan agreements. True

False

23. The cash cycle is the period between a firm's payment for materials and collection on its sales. True

False

24. Bank certificates of deposit are the safest and most liquid of all the money market securities. True

False

25. A firm's inventory period can be estimated by the ratio of inventory to daily cost of goods sold. True

False

26. Which of the following is not a current asset? A. an investment in a money market mutual fund. B. money due to suppliers. C. inventory of raw materials D. unpaid customer bills. 27. The economic order quantity: A. is the order size that minimizes the order costs. B. is independent of forecast sales. C. is based on sales, carrying costs, and order costs. D. increases as cost per order decreases. 28. Which of these firms will benefit the most from a lock-box service? A. A firm that has a large number of suppliers B. A firm that writes a large number of checks daily C. A firm that has a geographically dispersed customer base D. A firm that sells goods to a very limited number of customers 29. A firm that is located in New York receives on average 2,000 checks a day from its customers in the Twin Cities area. Average payment per check is $1,500. A bank in the Twin Cities is offering a lock-box arrangement for collection and processing of these checks at a cost of $0.50 per check. This arrangement will reduce the float by 2 days. The daily interest rate for the firm is 0.02%. What is the net saving from the lock-box arrangement? A. $200 B. $400 C. $1,000 D. $1,200 30. Which one of the following terms of sale is the most restrictive? A. Net 30 B. 2/10, net 4 C. CBD D. COD 31. At what point does a customer's unpaid account become delinquent when the terms of sale are 2/10, net 60? A. 11 days after the sale B. 31 days after the sale C. 61 days after the sale D. 71 days after the sale

32. Which statement is true about terms of trade credit of 2/10, net 30? A. A 10% cash discount is offered for payment before 30 days. B. A 2% cash discount can be taken for payment before the 10th of the following month. C. A 10% cash discount can be taken if paid by the second day after invoicing. D. No cash discount is offered after the tenth day. 33. What effective annual rate of interest is being charged to a customer who is granted credit terms of 3/15, net 45 when the customer foregoes the discount and pays on the last date prior to being delinquent? A. 44.86% B. 48.29% C. 37.67% D. 41.84% 34. What is the cash cycle for a firm with a receivables period of 40 days, a payables period of 30 days, and an inventory period of 60 days? A. 10 days. B. 50 days. C. 70 days. D. 130 days. 35. With terms of 4/15, net 60, what is the implied interest rate for forgoing a cash discount and paying at the end of the credit period? A. 25.63% B. 28.19% C. 39.25% D. 61.15% 36. What happens to the implied interest rate on trade credit as the time interval between the discount period and payment period is decreased? A. The rate declines. B. The rate increases. C. The rate remains constant. D. It is impossible to predict without knowing the actual length of discount period. 37. When sales are made without the accompaniment of a formal debt contract, the sales are said to be on: A. conditional sale terms. B. open account. C. trade credit. D. sight draft.

38. Under the terms of a sight draft, the buyer's bank: A. is instructed to make immediate payment. B. treats the invoice like a postdated check. C. forwards the acceptance to the seller until due. D. enters into a factoring arrangement. 39. A time draft that has been signed by the customer is termed: A. a trade discount. B. a conditional sale. C. a trade acceptance. D. an overdue account. 40. Which one of the following statements is correct about banker's acceptances? A. They are equivalent to a sight draft. B. They represent the norm for installment sales. C. The bank guarantees payment of the invoice. D. The bank retains title to the merchandise. 41. Which one of the following is not included in the five Cs of credit? A. Character B. Condition C. Consumption D. Capital 42. Credit scoring systems can be used to: A. reduce the effective cost of trade. B. determine the cost of goods sold. C. evaluate Dun and Bradstreet reports. D. evaluate credit risk based on the borrower's characteristics. 43. What is the cash cycle for a firm with $3 million average inventories, $1.5 million average accounts payable, a receivables period of 40 days, and annual sales of $20 million and an annual cost of goods sold of $18 million? A. 14.59 days. B. 46.25 days. C. 136.25 days. D. 70.42 days. 44. The set of rules that determines whether or not credit should be extended is known as: A. credit analysis. B. credit policy. C. multiple discriminate analysis. D. the terms of trade credit.

45. What credit decision is appropriate for a potential customer that offers a 75% chance of paying on a $10,000 sale which has an 80% cost? A. Grant credit since the expected profit is $3,200. B. Grant credit since the expected profit is $800. C. Refuse credit since the expected profit is negative. D. Refuse credit since the expected loss is zero. 46. What is the expected payoff on a $2,000 sale that has a 30% profit margin if there is a 20% probability of default? A. $1,000 B. $120 C. $600 D. $200 47. Firms should be more prepared to sell on credit to high-risk customers if: A. the profit margin is low. B. the probability of repeat orders is low. C. the profit margin is high. D. the firm’s sales representative is paid on commission. 48. Which one of the following statements typically describes the break-even probability of collection for repeat sale customers? A. The break-even probability is higher than for single sale customers. B. The break-even probability is lower than for single sale customers. C. The break-even probability does not change between single sale and repeat sale customers. D. Sales should never be refused for customers offering the potential of repeat sales. 49. An aging schedule illustrates the relationship between: A. the time history with a customer and the number of repeat sales. B. the average sale size and profitability over time. C. customer ages and the average size of sales. D. an accounts receivable and its time outstanding. 50. Money market securities usually have a maturity of: A. more than 1 year. B. less than 1 year. C. 1 to 3 years. D. less than a week. 51. A $1,200 invoice dated January 1 has credit terms of 3/10, net 30. If the buyer pays January 4, how much will he need to pay? A. $1,164 B. $1,080 C. $900 D. $1,200

52. Which of the following is correct concerning terms of trade credit of 4/10, EOM, net 90? A. The discount period expires on the last day of the month. B. The invoice becomes delinquent 90 days after the last day of the month. C. The discount period ends on the 10th day of the following month. D. The discount period ends either 10 days after invoicing or at the end of the month, whichever is earlier. 53. If goods are sold on terms of 5/10, net 90, what effective interest rate is if the purchaser pays on day 90? A. 20.00% B. 22.81% C. 24.93% D. 26.37% 54. Which one of the following changes to the terms of credit would increase the effective annual interest rate charged? A. Increasing the cash discount percentage B. Extending the discount period and payment period by 10 days each C. Extending the payment period only D. Decreasing the discount period only 55. Which one of the following is most likely to discourage purchasers from taking a discount? A. A higher discount percentage B. A shorter payment period C. A longer discount period D. A longer payment period 56. Which of the following strategies should a cash-strapped firm adopt if the effective interest rate charged on trade credit is lower than the bank's interest rate? A. Take the discount but pay after the discount period. B. Borrow from the bank and take the discount. C. Ignore the discount, pay at the end of the period. D. Take the discount and hope for longer payment float. 57. What is the daily net cost of holding a cash balance of $2.5 million, if the daily interest rate is 0.025% and the average transaction cost of investing money overnight is $50? A. $121 B. $171 C. $575 D. $675 58. Which one of the following credit agreements provides the least protection to the seller? A. Banker's acceptance B. Time draft C. Open account D. Commercial draft

59. The purpose of credit analysis is to: A. reconcile the accounts receivable balance. B. modify the terms of trade credit. C. organize the right side of the balance sheet. D. decide whether or not to grant credit to a customer. 60. Which one of the following would not be a customary source of credit information on customers? A. Dun and Bradstreet B. Chamber of Commerce C. Credit Bureau D. Customer's bank 61. The five Cs of credit refer to the: A. credit reports issued by Dun and Bradstreet. B. interpretation of numerical credit scoring systems. C. attributes that help determine creditworthiness. D. financial ratios used to determine a customer’s creditworthiness. 62. In field warehousing the inventory is held by the: A. borrowing firm. B. lending institution. C. independent warehousing company. D. firm and the lender jointly. 63. In general, a firm's credit policy should grant credit whenever the expected: A. loss from default is less than the cost of the product. B. profit from granting credit exceeds the profit from refusing. C. profit exceeds the price of the product. D. probability of a loss is less than 50%. 64. If the probability of collection is 65%, should you grant credit to a customer wishing to purchase a $2,000 item that cost $1,333.33 to produce? Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A. No; the expected loss is $33.33. B. No; the expected loss is $150.00. C. Yes; the expected profit is $33.33. D. Yes; the expected profit is $150.00. 65. What is the break-even probability in the following case? A customer wishes to purchase a $2,000 item that has been marked up to 50% over cost. Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A. 55.67% B. 66.67% C. 77.67% D. 88.67%

66. What is the minimum probability of collection that should be accepted by firms that have a 25% profit margin? Ignore the time value of money and assume that there is no chance of subsequence sales. A. 20% B. 25% C. 50% D. 75% 67. Which of the following would be more likely to justify granting credit? A. A higher profit margin B. A lower probability of payment C. A higher discount rate D. A lower selling price 68. Why should the possibility of a repeat order increase a firm’s willingness to grant credit? A. The expected cash flow from two orders is twice that from one order. B. The sales rep would earn increased commission. C. The customer can be given more time to pay. D. Payment on the first order increases the chance of payment on subsequent orders. 69. A revolving line of credit is: A. a secured loan to be amortized over three to five years. B. a one-time short-term, unsecured, amortized loan. C. an agreement allowing the firm to borrow up to a specific total amount on demand from a bank. D. a long-term, permanent source of funding. 70. A break-down of accounts receivable according to the length of time outstanding is known as a(n): A. amortization schedule. B. sources of cash flow statement. C. receivables inventory. D. aging schedule. 71. Check conversion is the process of: A. recording all checks electronically for retention purposes. B. displaying a copy of all your checks on your bank statements. C. debiting your bank account at the point of sale when you pay by check. D. converting a one-time payment into repetitive payments of equal amount. 72. Which type of inventory would a bank be most willing to accept as security for a loan? A. Cabbages growing in a farmer's field B. Produce on the shelves of a grocery store C. An inventory of t-shirts featuring the winners of last month’s Superbowl D. Boats owned by a boat dealer

73. A primary purpose of restricting the investment of idle cash balances to money market instruments is to: A. obtain government guarantees on the investment. B. minimize transaction costs. C. minimize interest-rate risk. D. maximize possible capital appreciation. 74. A firm's inventory and accounts payable periods are 80 and 42 days, respectively. If the cash cycle is 65 days, what is the firm's receivable period? A. 103 days B. 57 days C. 38 days D. 27 days 75. The longer the firm's accounts payable period, the: A. longer the firm's cash cycle. B. greater the delay in the accounts receivable period. C. less the firm must invest in net working capital. D. shorter the firm's inventory period. 76. Commercial paper is unsecured. Therefore, the companies that issue this short-term security: A. are typically large firms with top credit quality. B. frequently default. C. are typically small firms with top credit quality. D. are firms that have government-sponsored guarantees for the debt. 77. Which one of the following is not a carrying cost to holding inventory? A. Risk of being short of inventory and unable to satisfy orders B. Lost interest on funds tied up in inventory C. Spoilage D. Possible obsolescence 78. A firm is considering a one-time sale of $100,000 to a customer. The cost of goods sold for this sale is $90,000. If the probability of the customer paying is 0.8, what is the expected profit from this transaction? A. $0 B. −$10,000 C. +$8,000 D. +$10,000 79. What is the break-even probability of collection when the present value of revenues from a sale is $100,000 and the present value of cost is $87,000? A. 1.00 B. 0.87 C. 0.74 D. 0.13

80. A firm with ______ profit margin is best situated to extend credit to customers with a high probability of default. A. a high B. an average C. a low D. a zero 81. Term loans: A. may be parceled out among a syndicate of banks. B. are commonly self-liquidating. C. are traded on the New York Stock Exchange are traded on the New York Stock Exchange. D. are commonly repaid within 270 days. 82. What is the annual gain to a firm with daily sales of $30,000 if it can speed up collections by 3 days, assuming an annual opportunity cost of funds of 8%? A. $2,400 gain B. $7,200 gain C. $30,000 gain D. $90,000 gain 83. Which one of these is not a characteristic of a concentration system of collections? A. All surplus funds are electronically transferred to a centralized account. B. Check clearing times are increased. C. Customer payments are directed to a local collection center. D. Collection time is reduced. 84. The Canine Kennel uses 600 cases of dog food annually and orders 40 cases in each shipment. The annual carrying cost per case is $5 and the economic order quantity is 25 cases. Which one of these statements best applies to this situation? A. The current annual ordering costs exceed $5 per case. B. The firm needs to increase its average inventory level of dog food. C. The current annual ordering costs are less than the carrying costs. D. The firm needs to reduce the number of orders placed per year. 85. The Automated Clearing House (ACH) A. arranges for checks to be cleared. B. serves as an accounting system for credit cards. C. provides a mechanism for banks to transfer money directly to a firms’ suppliers or employees. D. is a system for making large-value international cash payments. 86. Potential savings from a lock-box system will be reduced by: A. the additional processing time required. B. the additional mailing time required. C. local bank charges. D. an increase in interest rates.

87. Which one of the following conditions would make a lock-box system potentially more attractive to a firm? A. Decline in interest rates B. A 2-day reduction in mail time rather than a 3-day reduction C. Larger payments D. Slower processing time 88. How much money can be saved annually by setting up a lock-box system that will process 500 checks per day at a cost of $0.15 per check if each check averages $220, collection float is reduced by 3 days, and the annual interest rate is 8%? (Use a 365-day year.) A. −$2,125 B. −$975 C. $2,650 D. $26,325 89. Which one of the following is not an inventory carrying cost? A. Insurance expense for the inventory B. Opportunity cost of capital for inventory investment C. Cost of buying raw materials D. Cost of shelf space 90. A 6-month Treasury bill sells at a discount of 5%. What is the effective annual interest rate? A. 2.564% B. 5.194% C. 5.063% D. 5.000% 91. If the marginal order cost exceeds the marginal carrying cost of inventory, then the firm: A. has minimized its total carrying costs. B. should increase its order size. C. should decrease its order size. D. has maximized its order costs. 92. Assume a firm can either hold cash paying no interest or invest in marketable securities. Which one of the following might induce the manager to hold higher cash balances today? A. The cost of borrowing is high relative to interest rates on marketable securities. B. Future cash flows are relatively predictable. C. The cost of cash balances is relatively high. D. Bank interest rates are expected to decrease. 93. Which of the following is not a money market instrument? A. U.S. Treasury bill with 91 days until maturity B. Commercial paper with 180 days until maturity C. 5-year Treasury bond D. A repurchase agreement, backed by U.S. government securities, with a 1-week maturity

94. Which one of the following statements is true of repurchase agreements? A. Their initial maturity is greater than 1 year. B. They are an unsecured form of borrowing. C. U.S. Treasury securities serve as their collateral. D. They make explicit, rather than implicit, interest payments. 95. Which of the following statements is false? A. Optimal inventory levels involve a trade-off between carrying costs and order costs. B. Carrying costs include the cost of storing goods as well as the cost of capital tied up in inventory. C. Optimal inventory levels are lower when storage or interest costs are high and are higher when restocking costs are high. D. Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal inventory level rises, but more than proportionately. 96. How much value would be added to a firm that could permanently reduce its cash collection period by 2 days if daily collections average $10,000 and the opportunity cost is 5% annually? A. $1,000 B. $1,200 C. $10,000 D. $20,000 97. Which of the following is not an advantage of wire transfer systems? A. makes record-keeping easier to automate. B. allows individuals to pay for goods when travelling abroad. C. can ensure that payments arrive exactly on time. D. very low cost to additional transactions.

Chapter 20 Test bank - Static Key 1.

Large payments between businesses are generally made electronically through either CHIPS or Fedwire. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash management processes

Inventory makes up the bulk of the current assets of retail firms. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-01 Understand why firms need to invest in working capital. Topic: Working capital requirements

The potential benefits of additional credit analysis should always be weighed against the incremental costs. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

Absent any possibility of repeat orders, if the default probability is less than the profit margin, you should extend credit for the sale. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

Firms are more likely to grant credit the higher the probability that a potential customer will become a repeat customer. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

The more liberal the terms of the collection policy, the lower the potential for bad debts and unprofitable sales. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Collection policy

A firm that buys on credit is in effect borrowing from its supplier. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Topic: Cost of credit

Just-in-time inventory management seeks to reduce inventory levels. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Inventory management.

Commercial paper is usually used to finance overseas trade. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-09 Understand the principal sources of short-term loans. Topic: Credit instruments

10.

Extending trade credit can increase the probability of repeat orders. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers.

Topic: Credit policy

11.

The decision to offer credit depends on the probability of payment. You should grant credit if the expected profit from doing so is greater than the profit from refusing. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

12.

Bond ratings are an expensive source of credit information on publicly traded companies. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

13.

An aging schedule is a statement sent to customers who are delinquent in their payments. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Collection policy

14.

Optimal inventory levels are lower when carrying costs are high, and when the cost of restocking inventories is low. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Inventory management.

15.

Since defaults can be costly, it is cost-effective to undertake a full credit analysis of all customers. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

16.

Checks that have been mailed but not yet cleared result in float. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Float costs and management

17.

Short-term securities have high interest-rate risk. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

18.

Lock-box systems allow local banks to collect and process the firm's remittances from that area. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash collections management

19.

As the number of inventory orders per year increases, the total order costs decrease. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Economic order quantity (EOQ) model

20.

Checks tend to be a more popular method of payment in the United States than in many other developed countries. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash management processes

21.

Most money market instruments have a high degree of liquidity. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

22.

Repos are long-term unsecured loan agreements. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

23.

The cash cycle is the period between a firm's payment for materials and collection on its sales. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-01 Understand why firms need to invest in working capital. Topic: Cash cycle

24.

Bank certificates of deposit are the safest and most liquid of all the money market securities. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

25.

A firm's inventory period can be estimated by the ratio of inventory to daily cost of goods sold. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-01 Understand why firms need to invest in working capital. Topic: Cash cycle

26.

Which of the following is not a current asset? A. an investment in a money market mutual fund. B. money due to suppliers. C. inventory of raw materials D. unpaid customer bills. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-01 Understand why firms need to invest in working capital. Topic: Working capital requirements

27.

The economic order quantity: A. is the order size that minimizes the order costs. B. is independent of forecast sales. C. is based on sales, carrying costs, and order costs. D. increases as cost per order decreases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Economic order quantity (EOQ) model Topic: Inventory management.

28.

Which of these firms will benefit the most from a lock-box service? A. A firm that has a large number of suppliers B. A firm that writes a large number of checks daily C. A firm that has a geographically dispersed customer base D. A firm that sells goods to a very limited number of customers AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash collections management

29.

A firm that is located in New York receives on average 2,000 checks a day from its customers in the Twin Cities area. Average payment per check is $1,500. A bank in the Twin Cities is offering a lock-box arrangement for collection and processing of these checks at a cost of $0.50 per check. This arrangement will reduce the float by 2 days. The daily interest rate for the firm is 0.02%. What is the net saving from the lock-box arrangement? A. $200 B. $400 C. $1,000 D. $1,200 Reduction in float = 2,000 × $1,500 × 2 days = $6m Daily interest savings = $6m × 0.0002 = $1,200 Daily processing cost = $0.50 × 2,000 = $1,000 Net daily savings = $1,200 − 1,000 = $200

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash collections management

30.

Which one of the following terms of sale is the most restrictive? A. Net 30 B. 2/10, net 4 C. CBD D. COD AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit terms

31.

At what point does a customer's unpaid account become delinquent when the terms of sale are 2/10, net 60? A. 11 days after the sale B. 31 days after the sale C. 61 days after the sale D. 71 days after the sale AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit terms

32.

Which statement is true about terms of trade credit of 2/10, net 30? A. A 10% cash discount is offered for payment before 30 days. B. A 2% cash discount can be taken for payment before the 10th of the following month. C. A 10% cash discount can be taken if paid by the second day after invoicing. D. No cash discount is offered after the tenth day. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit terms

33.

What effective annual rate of interest is being charged to a customer who is granted credit terms of 3/15, net 45 when the customer foregoes the discount and pays on the last date prior to being delinquent? A. 44.86% B. 48.29% C. 37.67% D. 41.84% EAR = [1 + (0.03 / (1 − 0.03))]365 / (45 − 15) − 1 = 0.4486, or 44.86%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Topic: Costs of credit

34.

What is the cash cycle for a firm with a receivables period of 40 days, a payables period of 30 days, and an inventory period of 60 days? A. 10 days. B. 50 days. C. 70 days. D. 130 days. Cash conversion cycle = 60 + 40 − 30 = 70 days

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-01 Understand why firms need to invest in working capital. Topic: Cash cycle

35.

With terms of 4/15, net 60, what is the implied interest rate for forgoing a cash discount and paying at the end of the credit period? A. 25.63% B. 28.19% C. 39.25% D. 61.15% EAR = [1 + (0.04 / (1 − 0.04))]365 / (60 − 15) − 1 = 0.3925, or 39.25%

36.

What happens to the implied interest rate on trade credit as the time interval between the discount period and payment period is decreased? A. The rate declines. B. The rate increases. C. The rate remains constant. D. It is impossible to predict without knowing the actual length of discount period. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Topic: Credit terms

37.

When sales are made without the accompaniment of a formal debt contract, the sales are said to be on: A. conditional sale terms. B. open account. C. trade credit. D. sight draft. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit instruments

38.

Under the terms of a sight draft, the buyer's bank: A. is instructed to make immediate payment. B. treats the invoice like a postdated check. C. forwards the acceptance to the seller until due. D. enters into a factoring arrangement. AACSB: Communication

Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit instruments

39.

A time draft that has been signed by the customer is termed: A. a trade discount. B. a conditional sale. C. a trade acceptance. D. an overdue account. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit instruments

40.

Which one of the following statements is correct about banker's acceptances? A. They are equivalent to a sight draft. B. They represent the norm for installment sales. C. The bank guarantees payment of the invoice. D. The bank retains title to the merchandise. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit instruments

41.

Which one of the following is not included in the five Cs of credit? A. Character B. Condition C. Consumption D. Capital AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

42.

Credit scoring systems can be used to: A. reduce the effective cost of trade. B. determine the cost of goods sold. C. evaluate Dun and Bradstreet reports. D. evaluate credit risk based on the borrower's characteristics. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

43.

What is the cash cycle for a firm with $3 million average inventories, $1.5 million average accounts payable, a receivables period of 40 days, and annual sales of $20 million and an annual cost of goods sold of $18 million? A. 14.59 days. B. 46.25 days. C. 136.25 days. D. 70.42 days. Cash conversion cycle = $3m / ($18m / 365) + 40 − $1.5m / ($18m / 365) = 70.42 days

44.

The set of rules that determines whether or not credit should be extended is known as: A. credit analysis. B. credit policy. C. multiple discriminate analysis. D. the terms of trade credit. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

45.

What credit decision is appropriate for a potential customer that offers a 75% chance of paying on a $10,000 sale which has an 80% cost? A. Grant credit since the expected profit is $3,200. B. Grant credit since the expected profit is $800. C. Refuse credit since the expected profit is negative. D. Refuse credit since the expected loss is zero. Expected profit from offering credit = 0.75 × PV($10,000 − 8,000) − 0.25 × PV($8,000) < $0

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

46.

What is the expected payoff on a $2,000 sale that has a 30% profit margin if there is a 20% probability of default? A. $1,000 B. $120 C. $600 D. $200 Expected payoff = 0.8 × 0.3 × $2,000 − (0.2 × 0.70 × $2,000) = $200

47.

Firms should be more prepared to sell on credit to high-risk customers if: A. the profit margin is low. B. the probability of repeat orders is low. C. the profit margin is high. D. the firm’s sales representative is paid on commission. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

48.

Which one of the following statements typically describes the break-even probability of collection for repeat sale customers? A. The break-even probability is higher than for single sale customers. B. The break-even probability is lower than for single sale customers. C. The break-even probability does not change between single sale and repeat sale customers. D. Sales should never be refused for customers offering the potential of repeat sales. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit analysis

49.

An aging schedule illustrates the relationship between: A. the time history with a customer and the number of repeat sales. B. the average sale size and profitability over time. C. customer ages and the average size of sales. D. an accounts receivable and its time outstanding. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Collection policy

50.

Money market securities usually have a maturity of: A. more than 1 year. B. less than 1 year. C. 1 to 3 years. D. less than a week. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

51.

A $1,200 invoice dated January 1 has credit terms of 3/10, net 30. If the buyer pays January 4, how much will he need to pay? A. $1,164 B. $1,080 C. $900 D. $1,200 Discounted payment = (1 − 0.03) × $1,200 = $1,164

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit terms

52.

Which of the following is correct concerning terms of trade credit of 4/10, EOM, net 90? A. The discount period expires on the last day of the month. B. The invoice becomes delinquent 90 days after the last day of the month. C. The discount period ends on the 10th day of the following month. D. The discount period ends either 10 days after invoicing or at the end of the month, whichever is earlier. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit terms

53.

If goods are sold on terms of 5/10, net 90, what effective interest rate is if the purchaser pays on day 90? A. 20.00% B. 22.81% C. 24.93% D. 26.37% EAR = [1 + (0.05 / (1 − 0.05))]365 / (90 − 10) − 1 = 0.2637, or 26.37%

54.

Which one of the following changes to the terms of credit would increase the effective annual interest rate charged? A. Increasing the cash discount percentage B. Extending the discount period and payment period by 10 days each C. Extending the payment period only D. Decreasing the discount period only AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 3 Hard Gradable: automatic Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Topic: Costs of credit

55.

Which one of the following is most likely to discourage purchasers from taking a discount? A. A higher discount percentage B. A shorter payment period C. A longer discount period D. A longer payment period AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit terms

56.

Which of the following strategies should a cash-strapped firm adopt if the effective interest rate charged on trade credit is lower than the bank's interest rate? A. Take the discount but pay after the discount period. B. Borrow from the bank and take the discount. C. Ignore the discount, pay at the end of the period. D. Take the discount and hope for longer payment float. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-03 Measure the implicit interest rate on credit sales. Topic: Cost of credit

57.

What is the daily net cost of holding a cash balance of $2.5 million, if the daily interest rate is 0.025% and the average transaction cost of investing money overnight is $50? A. $121 B. $171 C. $575 D. $675 Net opportunity cost = (0.00025 × $2.5m) − $50 = $575

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash management general

58.

Which one of the following credit agreements provides the least protection to the seller? A. Banker's acceptance B. Time draft C. Open account D. Commercial draft AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Credit instruments

59.

The purpose of credit analysis is to: A. reconcile the accounts receivable balance. B. modify the terms of trade credit. C. organize the right side of the balance sheet. D. decide whether or not to grant credit to a customer. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

60.

Which one of the following would not be a customary source of credit information on customers? A. Dun and Bradstreet B. Chamber of Commerce C. Credit Bureau D. Customer's bank AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

61.

The five Cs of credit refer to the: A. credit reports issued by Dun and Bradstreet. B. interpretation of numerical credit scoring systems. C. attributes that help determine creditworthiness. D. financial ratios used to determine a customer’s creditworthiness. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills. Topic: Credit analysis

62.

In field warehousing the inventory is held by the: A. borrowing firm. B. lending institution. C. independent warehousing company. D. firm and the lender jointly. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Inventory management.

63.

In general, a firm's credit policy should grant credit whenever the expected: A. loss from default is less than the cost of the product. B. profit from granting credit exceeds the profit from refusing. C. profit exceeds the price of the product. D. probability of a loss is less than 50%. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

64.

If the probability of collection is 65%, should you grant credit to a customer wishing to purchase a $2,000 item that cost $1,333.33 to produce? Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A. No; the expected loss is $33.33. B. No; the expected loss is $150.00. C. Yes; the expected profit is $33.33. D. Yes; the expected profit is $150.00. Expected profit = 0.65[$2,000 − $1,333.33] − (1 − 0.65)[$$1,333.33] = −$33.33

65.

What is the break-even probability in the following case? A customer wishes to purchase a $2,000 item that has been marked up to 50% over cost. Assume all cash flows are discounted to present value and there is no chance of subsequent sales. A. 55.67% B. 66.67% C. 77.67% D. 88.67% p = profit margin = 0.6667, or 66.67%

66.

What is the minimum probability of collection that should be accepted by firms that have a 25% profit margin? Ignore the time value of money and assume that there is no chance of subsequence sales. A. 20% B. 25% C. 50% D. 75% AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

67.

Which of the following would be more likely to justify granting credit? A. A higher profit margin B. A lower probability of payment C. A higher discount rate D. A lower selling price AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

68.

Why should the possibility of a repeat order increase a firm’s willingness to grant credit? A. The expected cash flow from two orders is twice that from one order. B. The sales rep would earn increased commission. C. The customer can be given more time to pay. D. Payment on the first order increases the chance of payment on subsequent orders. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

69.

A revolving line of credit is: A. a secured loan to be amortized over three to five years. B. a one-time short-term, unsecured, amortized loan. C. an agreement allowing the firm to borrow up to a specific total amount on demand from a bank. D. a long-term, permanent source of funding. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Credit analysis

70.

A break-down of accounts receivable according to the length of time outstanding is known as a(n): A. amortization schedule. B. sources of cash flow statement. C. receivables inventory. D. aging schedule. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy. Topic: Collection policy

71.

Check conversion is the process of: A. recording all checks electronically for retention purposes. B. displaying a copy of all your checks on your bank statements. C. debiting your bank account at the point of sale when you pay by check. D. converting a one-time payment into repetitive payments of equal amount. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash management processes

72.

Which type of inventory would a bank be most willing to accept as security for a loan? A. Cabbages growing in a farmer's field B. Produce on the shelves of a grocery store C. An inventory of t-shirts featuring the winners of last month’s Superbowl D. Boats owned by a boat dealer AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Credit terms

73.

A primary purpose of restricting the investment of idle cash balances to money market instruments is to: A. obtain government guarantees on the investment. B. minimize transaction costs. C. minimize interest-rate risk. D. maximize possible capital appreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

74.

A firm's inventory and accounts payable periods are 80 and 42 days, respectively. If the cash cycle is 65 days, what is the firm's receivable period? A. 103 days B. 57 days C. 38 days D. 27 days Cash cycle = 65 = A / R period + 80 − 42; A / R period = 27 days

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-01 Understand why firms need to invest in working capital. Topic: Cash cycle

75.

The longer the firm's accounts payable period, the: A. longer the firm's cash cycle. B. greater the delay in the accounts receivable period. C. less the firm must invest in net working capital. D. shorter the firm's inventory period. AACSB: Communication Accessibility: Keyboard Navigation

Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-01 Understand why firms need to invest in working Cash cycle analysis

76.

Commercial paper is unsecured. Therefore, the companies that issue this short-term security: A. are typically large firms with top credit quality. B. frequently default. C. are typically small firms with top credit quality. D. are firms that have government-sponsored guarantees for the debt. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Credit terms

77.

Which one of the following is not a carrying cost to holding inventory? A. Risk of being short of inventory and unable to satisfy orders B. Lost interest on funds tied up in inventory C. Spoilage D. Possible obsolescence AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Inventory management.

78.

A firm is considering a one-time sale of $100,000 to a customer. The cost of goods sold for this sale is $90,000. If the probability of the customer paying is 0.8, what is the expected profit from this transaction? A. $0 B. −$10,000 C. +$8,000 D. +$10,000 Expected profit = 0.8($100,000 − 90,000) − (1 − 0.8)($90,000) = −$10,000

79.

What is the break-even probability of collection when the present value of revenues from a sale is $100,000 and the present value of cost is $87,000? A. 1.00 B. 0.87 C. 0.74 D. 0.13 p = $87,000 / $100,000 = 0.87

80.

A firm with ______ profit margin is best situated to extend credit to customers with a high probability of default. A. a high B. an average C. a low D. a zero AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-05 Understand when it makes sense to grant credit to customers. Topic: Credit policy

81.

Term loans: A. may be parceled out among a syndicate of banks. B. are commonly self-liquidating. C. are traded on the New York Stock Exchange are traded on the New York Stock Exchange. D. are commonly repaid within 270 days. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Credit analysis

82.

What is the annual gain to a firm with daily sales of $30,000 if it can speed up collections by 3 days, assuming an annual opportunity cost of funds of 8%? A. $2,400 gain B. $7,200 gain C. $30,000 gain D. $90,000 gain Float is reduced by $90,000. If invested at 8% a year, gain = $90,000 × 0.08 = $7,200

83.

Which one of these is not a characteristic of a concentration system of collections? A. All surplus funds are electronically transferred to a centralized account. B. Check clearing times are increased. C. Customer payments are directed to a local collection center. D. Collection time is reduced. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash collections management

84.

The Canine Kennel uses 600 cases of dog food annually and orders 40 cases in each shipment. The annual carrying cost per case is $5 and the economic order quantity is 25 cases. Which one of these statements best applies to this situation? A. The current annual ordering costs exceed $5 per case. B. The firm needs to increase its average inventory level of dog food. C. The current annual ordering costs are less than the carrying costs. D. The firm needs to reduce the number of orders placed per year. At 40 cases per order, the size of the order exceeds the EOQ of 25 cases. This means the carrying costs are larger than the order costs. See Figure 20.7 in the text.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Economic order quantity (EOQ) model Topic: Inventory management.

85.

The Automated Clearing House (ACH) A. arranges for checks to be cleared. B. serves as an accounting system for credit cards. C. provides a mechanism for banks to transfer money directly to a firms’ suppliers or employees. D. is a system for making large-value international cash payments. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash management processes

86.

Potential savings from a lock-box system will be reduced by: A. the additional processing time required. B. the additional mailing time required. C. local bank charges. D. an increase in interest rates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash collections management

87.

Which one of the following conditions would make a lock-box system potentially more attractive to a firm? A. Decline in interest rates B. A 2-day reduction in mail time rather than a 3-day reduction C. Larger payments D. Slower processing time AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash collections management

88.

How much money can be saved annually by setting up a lock-box system that will process 500 checks per day at a cost of $0.15 per check if each check averages $220, collection float is reduced by 3 days, and the annual interest rate is 8%? (Use a 365-day year.) A. −$2,125 B. −$975 C. $2,650 D. $26,325 Annual savings = (500 × $220 × 3 × 0.08) − (500 × $0.15 × 365) = −$975

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash collections management

89.

Which one of the following is not an inventory carrying cost? A. Insurance expense for the inventory B. Opportunity cost of capital for inventory investment C. Cost of buying raw materials D. Cost of shelf space AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Inventory costs Topic: Inventory management.

90.

A 6-month Treasury bill sells at a discount of 5%. What is the effective annual interest rate? A. 2.564% B. 5.194% C. 5.063% D. 5.000% Price of bill = 100 − 5 / 2 = 97.5 Annual interest rate = (100 / 97.5)2 − 1 = 0.05194

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

91.

If the marginal order cost exceeds the marginal carrying cost of inventory, then the firm: A. has minimized its total carrying costs. B. should increase its order size. C. should decrease its order size. D. has maximized its order costs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-06 Cite the costs and benefits of holding inventories. Topic: Economic order quantity (EOQ) model

Topic: Inventory costs

92.

Assume a firm can either hold cash paying no interest or invest in marketable securities. Which one of the following might induce the manager to hold higher cash balances today? A. The cost of borrowing is high relative to interest rates on marketable securities. B. Future cash flows are relatively predictable. C. The cost of cash balances is relatively high. D. Bank interest rates are expected to decrease. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash management general

93.

Which of the following is not a money market instrument? A. U.S. Treasury bill with 91 days until maturity B. Commercial paper with 180 days until maturity C. 5-year Treasury bond D. A repurchase agreement, backed by U.S. government securities, with a 1-week maturity AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-07 Compare alternatives for investing excess funds over short horizons. Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

94.

Which one of the following statements is true of repurchase agreements? A. Their initial maturity is greater than 1 year. B. They are an unsecured form of borrowing. C. U.S. Treasury securities serve as their collateral. D. They make explicit, rather than implicit, interest payments. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Money market securities

95.

Which of the following statements is false? A. Optimal inventory levels involve a trade-off between carrying costs and order costs. B. Carrying costs include the cost of storing goods as well as the cost of capital tied up in inventory. C. Optimal inventory levels are lower when storage or interest costs are high and are higher when restocking costs are high. D. Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal inventory level rises, but more than proportionately. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market. Topic: Inventory management.

96.

How much value would be added to a firm that could permanently reduce its cash collection period by 2 days if daily collections average $10,000 and the opportunity cost is 5% annually? A. $1,000 B. $1,200 C. $10,000 D. $20,000 PV of daily interest = [$10,000 × 2 × (0.05 / 365)] / (0.05 / 365) = $20,000

97.

Which of the following is not an advantage of wire transfer systems? A. makes record-keeping easier to automate. B. allows individuals to pay for goods when travelling abroad. C. can ensure that payments arrive exactly on time. D. very low cost to additional transactions. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments. Topic: Cash management processes

Chapter 20 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 20-01 Understand why firms need to invest in working capital.

Learning Objective: 20-01 Understand why firms need to invest in working Cash cycle analysis

Learning Objective: 20-02 Describe the usual steps in a firm’s credit management policy.

Learning Objective: 20-03 Measure the implicit interest rate on credit sales.

Learning Objective: 20-04 Describe how firms assess the probability that a customer will pay its bills.

Learning Objective: 20-05 Understand when it makes sense to grant credit to Credit policy customers.

Learning Objective: 20-05 Understand when it makes sense to grant credit to customers.

Learning Objective: 20-06 Cite the costs and benefits of holding inventories.

Learning Objective: 20-07 Compare alternatives for investing excess funds over short horizons.

Learning Objective: 20-07 Compare the different techniques that firms use to make and receive payments.

Learning Objective: 20-08 Compare alternatives for investing idle cash and interpret interest rates in the money market.

Learning Objective: 20-09 Understand the principal sources of short-term loans.

Topic: Cash collections management

Topic: Cash cycle

Topic: Cash management general

Topic: Cash management processes

Topic: Collection policy

Topic: Cost of credit

Topic: Costs of credit

Topic: Credit analysis

Topic: Credit instruments

Topic: Credit policy

Topic: Credit terms

Topic: Economic order quantity (EOQ) model

Topic: Float costs and management

Topic: Inventory costs

Topic: Inventory management.

Topic: Money market securities

Topic: Working capital requirements

Chapter 21 Test bank - Static Student: ___________________________________________________________________________

When a firm is taken over, its management is usually replaced. True

Takeovers are often described as part of a broader market for corporate control. True

False

Changing management is the only reason that firms make acquisitions. True

False

If a segment of a business is unrelated to the rest of the firm's activities, that segment is more likely to be spun off or carved out. True

False

Carve-outs and spin-offs both provide shares of the new firm to the divesting firm's shareholders. True

False

Allergan’s sale of its generic drug business to Teva Pharmaceutical was an example of a divestiture. True

False

A vertical merger is one between firms at different levels of the production process. True

False

A merger must have the approval of at least 51% of the shareholders of each firm. True

False

10. The expected savings from merging two banks often come from consolidating operations and eliminating redundant costs. True

False

11. A conglomerate merger is defined as the merger of two or more Fortune 500 companies. True

False

12. It is always more efficient to integrate vertically than to outsource part of one’s business. True

False

13. By offering to buy shares directly from a target’s shareholders, the acquiring firm can bypass the target firm's management altogether. True

False

14. Vertical integration makes sense when two firms are highly dependent upon each other. True

False

15. Evidence shows that investors will generally pay a premium for diversified firms. That is a good reason for firms to merge. True

False

16. Synergy is equal to the value of a combined firm minus the total value of the firms prior to merger. True

False

17. Target firms frequently deter potential bidders by devising poison pills, which make the company unappetizing. True

False

18. Strictly speaking, the purchase of the stock or assets of another firm is an acquisition. True

False

19. A typical poison pill may give existing shareholders the right to buy the company's shares at half price as soon as a bidder acquires more than 15% of the shares. The bidder is not entitled to the discount. True

False

20. Firm A's shareholders will be better off with a stock offer than with a cash offer if A makes too generous of an offer for Firm B. True

False

21. The Williams Act in addition to state laws sets forth the rules for tender offers. True

False

22. Economies of vertical integration are one possible source of synergy in mergers. True

False

23. Contrary to logic, firms that enjoy complementary resources in the production process are rarely good candidates for merger. True

False

24. An economic gain is derived from mergers when two firms are worth more combined than separate. True

False

25. Amendments to the corporate charter that attempt to circumvent mergers are known as poison pills. True

False

26. On average, stockholders in target firms earn higher returns from mergers than the acquiring firm's stockholders. True

False

27. If investors believe a firm may be acquired, its market value is likely to be higher than its stand-alone value. True

False

28. Management buyouts are generally all-equity financed by the new shareholders. True

False

29. Cross-border mergers are often motivated by tax considerations. True

False

30. Tax inversion refers to the fact that mergers often result in extra capital gains taxes for shareholders. True

False

31. One motive for acquiring a firm is to stop wastage of the target firm's cash reserves. True

False

32. The 1980s were a time of little merger activity. True

False

33. In general, shareholders of the target firm benefit from takeovers. True

False

34. Leveraged buyouts are acquisitions where a large fraction of the purchase price is financed with debt. True

False

35. The value of the target firm's bonds tend to decrease when a leveraged buyout is announced. True

False

36. The free-cash-flow theory supports the notion that the market gain from an LBO is basically the present value of the firm's future cash flows that would otherwise have been wasted. True

False

37. Only the U.S. has antitrust laws that can affect mergers and acquisitions. True

False

38. In a merger the acquiring firm buys only the debt of the target firm. True

False

39. It is easier for individual investors to diversify their risk by buying shares in different firms than for the firms to combine their operations. True

False

40. In mergers financed by cash, the merger cost is not affected by the size of the merger gain. True

False

41. When shareholders attempt to garner additional votes in an attempt to oust management, it is called a: A. management buyout. B. tender offer. C. proxy contest. D. poison pill. 42. When one firm merges with another, the: A. boards of directors will merge also. B. merger must be approved by 75% of the shareholders of the target firm. C. assets will be merged but the liabilities will not. D. target firm will cease to exist as a separate public company. 43. A tender offer is one in which the firm's: A. management offers to sell the company to an acquirer. B. board of directors offers to sell the company to the public. C. shareholders are given the opportunity to sell their shares to a would-be acquirer. D. management offers to buy all outstanding shares of the corporation. 44. When an outside group acquires a firm, primarily through the use of borrowed funds, the acquisition is known as a: A. management buyout. B. tender offer. C. leveraged buyout. D. successful proxy fight. 45. When a firm's management takes the firm private with the aid of substantial debt, it is known as a management: A. tender offer. B. greenmail offer. C. buyout. D. hostile takeover. 46. A spinoff is an action in which: A. the management bids for and acquires the firm. B. one firm issues stock to acquire another firm. C. successful product lines are sold to competitors. D. a portion of the firm's assets is sold off to form a new company.

47. If an automobile manufacturer were to acquire one of the firms listed below, which acquisition would be called a horizontal merger? A. A steel mill B. A rival manufacturer C. A tire producer D. A bank 48. If Snapper Lawnmowers were to acquire Briggs and Stratton (gasoline-powered engines), the merger would be classified as a: A. conglomerate. B. leveraged buyout. C. horizontal merger. D. vertical merger. 49. A conglomerate merger occurs when: A. both partners are large in size. B. large synergies are expected to develop. C. firms from different industries merge. D. both management teams remain intact after the merger. 50. Mergers may provide reductions in average production cost as a result of: A. increased market price. B. increased financing. C. economies of scale. D. diversification. 51. Which one of the following might you recommend to a firm with excessive free cash flow? A. Acquire a firm to diversify B. Acquire a firm to bootstrap earnings C. A leveraged buyout D. A repurchase of shares 52. Diversification is often a poor motive for mergers because: A. vertical integration is rarely successful. B. investors can diversify on their own account. C. it does not produce economies of scale. D. the increase in taxes overcomes any gains in earnings. 53. One indication that investors expect no synergy from a merger would be that the: A. total market value of the merged firms does not change. B. P/E ratio of the merged firms' changes. C. acquiring firm financed the merger with cash. D. merged firms are from different industries.

54. An increase in earnings per share may be increased by a merger if the: A. number of shares has increased. B. price of the acquirer's stock increases. C. acquirer’s P/E ratio is higher than that of the target. D. firm's additional earnings are spent on legal expenses of the merger. 55. The cost of a merger may outweigh the potential gain if the: A. present value of the acquired firm exceeds the price paid for it. B. present value of the merged firms is greater than the sum of their individual values. C. merger allows cost savings to occur. D. acquired firm's shareholders receive more than the value of their firm. 56. Firm B's 1 million shares of stock currently sell for $12 each, but firm A is preparing a tender offer of $18 per share. Firm A estimates the NPV of the merger to be $5 million. What percentage of the merger gains will be captured by firm B's stockholders? A. 33.33% B. 50.00% C. 66.67% D. 54.55% 57. The cost of a merger equals the: A. cash paid for the target firm. B. increase in total earnings minus the price paid. C. premium paid over the target's value as a separate entity. D. sum of cash and stock paid for the target firm. 58. ABC Corp. has offered 1 million shares having a total market value of $8 million for XYZ. After the merger is announced, shares in ABC trade for $7 each. If ABC is confident about XYZ's value, then the cost of the merger: A. increased by $1 million. B. decreased by $1 million. C. increased by $9 million. D. remained constant. 59. In the case of a merger that is stock financed, the merger cost may change if the: A. value of the target firm's shares changes after the merger announcement. B. value of the acquiring firm's shares changes after the merger announcement. C. long-term interest rates increase. D. merger is either horizontal or vertical. 60. The shareholders of firm A have offered 1 million shares valued at $10 each to acquire firm B. After the merger is announced, stock A trades for $9 per share. Which of the following statements is false? A. Firm A appears to have overbid for firm B. B. The NPV of the merger may differ from expectations. C. Shareholders of firm A absorb all the additional "cost." D. Firm A's stockholders are better off than if the merger were cash financed for $10 million.

61. Large-scale efforts to make a firm less appealing in the midst of a potential merger are known as: A. proxy fights. B. leveraged buyouts. C. shark attractants. D. poison pills. 62. Other things equal, which one of the following groups of stakeholders often lose value as a result of an LBO? A. Selling stockholders B. Buying stockholders C. Pre-LBO bondholders D. Investment bankers 63. The free-cash-flow theory of takeovers predicts that firms: A. without free cash flow will become the most common LBOs. B. with free cash flow will continue to be the acquirers. C. with excess cash do not have a tendency to use it wisely. D. with excess cash tend to have the most carve-outs. 64. A change to the corporate charter that requires that any merger must be approved by a supermajority of shareholders is known as: A. an LBO. B. a proxy contest. C. a carve-out. D. a shark-repellent. 65. Which of the following is not a mechanism for changing a firm’s management? A. A proxy contest B. A leveraged buyout C. A poison pill D. A takeover 66. Proxy fights generally occur when a group is trying to: A. rewrite the corporate charter. B. bring about economies of scale. C. replace the current board and management team. D. pursue a public tender offer. 67. One of the reasons why proxy fights are often unsuccessful is that: A. management is always viewed as performing its job well. B. management can use corporate resources to defend against the fight. C. mergers are a cheaper form of changing management. D. shareholders are unconcerned with corporate management.

68. Which one of the following is false concerning a proposed merger of firms? A. The acquired firm will cease to exist. B. Shareholders of the acquired firm may receive securities in the acquiring firm. C. Mergers are sometimes combinations of equals. D. Shareholder approval to merge is not required. 69. A public offer to purchase the shares of existing stockholders in order to take the firm over is called a: A. tender offer. B. carve-out. C. spin-off. D. divestiture. 70. When a management team buys the firm from current shareholders while continuing to manage and often incurring large segments of debt, it is known as a: A. management buyout. B. spin-off. C. successful greenmail attempt. D. corporate breakup. 71. If Georgia Pacific (lumber products) were to acquire a national homebuilding firm, the combination would be termed a: A. horizontal merger. B. vertical merger. C. conglomerate merger. D. spin-off by the national homebuilding firm. 72. Which one of the following is least likely to provide a motivation for vertical integration? A. A continuous source of raw materials B. A desire to spread fixed costs across more output C. Access to an efficient distribution channel D. Acquisition of an established customer base 73. Cash-rich firms often make questionable acquisitions, rather than pay out the cash to shareholders. This: A. is because diversification is too costly for individuals. B. is an example of an agency problem. C. is because diversification eliminates inefficiencies. D. is an example of the bootstrap game. 74. Firms with substantial amounts of free cash flow often discover that: A. conglomerate mergers are the best use for the funds. B. accounting profits are what truly matter. C. they have become takeover targets. D. their capital budgets have been too low.

75. The "Bootstrap Game" is played somewhat in defiance of traditional merger logic in that it: A. provides immediate benefit through improved management. B. does not offer a positive NPV from the merger. C. stays in effect only until EPS are increased. D. does not require the approval of a majority of shareholders. 76. Mergers that attempt to bootstrap earnings may obtain increased current earnings per share at the expense of: A. a higher price-earnings ratio. B. higher total combined market value. C. reduced future growth prospects. D. increased free cash flow. 77. Firms that are acquired to take advantage of bootstrapping often have: A. a lower price-earnings ratio than the acquirer. B. a higher price-earnings ratio than the acquirer. C. more outstanding shares than the acquirer. D. a higher market valuation than the acquirer. 78. If two merged firms are shown to have a higher combined market value than the sum of their individual market values, then: A. there are economic gains. B. the firms were previously underpriced. C. the merger provides diversification to investors. D. there is no cost involved in the merger. 79. If the shareholders of an acquired firm capture all of the merger's gain, then the: A. cost of the merger is zero. B. NPV of the merger is zero. C. EPS will increase. D. acquiring firm retains all merger benefits. 80. Why is it not sufficient to state that a merger should occur simply because the economic gains are positive? A. Gains are typically of an accounting nature. B. Shareholders of the target firm may capture all of the gains. C. Merger costs should be negative after discounting. D. The merger's gain must also exceed its NPV. 81. Firms A and B were each currently worth $50 million but generated a $20 million gain when merged. If the cost of the merger was $5 million, how much did firm A pay for firm B? A. $50 million B. $55 million C. $60 million D. $65 million

82. When two firms merge, the value of the acquiring firm will change by the: A. gain from the merger. B. NPV minus the cost of the merger. C. NPV of the merger. D. cost of the merger. 83. CBA Corp. is worth $15 million as a stand-alone firm. ABC Corp. has offered 350,000 shares valued at $50 each to acquire CBA. After the announcement, however, the price of ABC's shares falls to $45. What was the cost of the merger? A. −$1.75 million B. $0.75 million C. $1.75 million D. $3.25 million 84. Which one of the following statements is correct concerning the cost of two firms merging? The cost: A. is fixed when the merger is financed with cash. B. can be affected by postmerger gains if cash is used. C. decreases as the postmerger share price increases when stock is used to finance the merger. D. is not determined until after the merger, regardless of the type of financing. 85. Why might shareholders of an acquiring firm prefer to finance mergers with stock rather than with cash? A. Stock financing is always less costly due to tax consequences. B. The EPS decreases when mergers are financed with cash. C. Target-firm shareholders will bear part of the cost if merger benefits were overestimated. D. All merger gains go to the acquirer when financed with stock. 86. Realizing the benefits of a merger is easier when the merging companies have differing: A. computer systems. B. pay structures. C. resources. D. company cultures. 87. The most likely interpretation of headlines that read "ABC Corp. adopts shark repellent" is that ABC: A. wants to increase the difficulty of a takeover. B. has made a tender offer for the shares of another firm. C. will merge only with small-sized partners. D. desires to reduce the costs of being acquired. 88. Shares of a corporation can, under certain circumstances, be priced at different amounts to different investors under the terms of a: A. proxy agreement. B. public tender offer. C. poison pill. D. shark repellent.

89. What does empirical evidence suggest about the distribution of gains from mergers? A. Shareholders of the acquired firm gain the most. B. Shareholders of the acquiring firm gain the most. C. Neither group of shareholders is likely to gain. D. Both groups of shareholders gain equally. 90. What type of financing is typically instrumental in bringing about leveraged buyouts? A. Common-stock financing B. Preferred-stock financing C. Investment-grade bonds D. Speculative-grade bonds 91. According to the free-cash-flow theory of takeovers, many acquisitions are motivated by: A. an illogical assessment of earnings prospects. B. the remaining costs of the merger. C. the belief that free cash flow will no longer be misused. D. losses experienced by arbitrageurs and other speculators. 92. Firm B's 1 million shares of stock currently sell for $20 each. Firm A estimates the economic gain from the merger to be $10 million and is prepared to offer $22 cash for each share of B. What percentage of the merger gain will be captured by firm B's shareholders? A. 20.00% B. 33.33% C. 50.00% D. 60.00% 93. XYZ Corp has made a cash tender offer for 2 million shares of ABC Corp. at a price of $20, which is $6 higher than ABC's current stand-alone value. What is the cost of the merger? A. $40 million B. $28 million C. $12 million D. Zero 94. A merger is expected to produce cost savings of $50 million and the acquired firm's shareholders will receive a premium of 20% over the $150 million value of their firm. The gain of the merger to the acquirer is: A. $20 million. B. $30 million. C. $50 million. D. $130 million. 95. Which one of the following is not a method of changing the management of a firm? A. Proxy contest B. Merger and acquisition C. LBO D. MBO

96. Which one of the following is correct concerning a spin-off? A. A division of a firm is reconstituted as a new firm. B. An unprofitable division is divested. C. A division of a firm is bought by its managers. D. The spin-off generates no free cash flow. 97. Splitting one firm into four separate firms is an example of a: A. leveraged buyout. B. spin-off. C. management buyout. D. tender offer. 98. The merger between Uptown Bank and Downtown Bank is an example of a: A. vertical merger. B. horizontal merger. C. conglomerate merger. D. direct merger. 99. If Microsoft were to acquire Dell Computer, it would be an example of a: A. vertical merger. B. horizontal merger. C. conglomerate merger. D. distribution-channel merger. 100. Conglomerate mergers involve companies in: A. similar lines of business. B. different stages of the corporate life cycle. C. unrelated lines of business. D. different countries. 101. A merger adds value by creating synergies. Which one of these is not a possible source of synergy? A. Economies of scale B. Economies of vertical integration C. Combined complementary resources D. Diversification 102. Which one of the following is the most appropriate reason for an acquiring firm's shareholders to prefer using stock financing for acquisitions? A. There is no cash outflow. B. It mitigates the effects of overvaluation of the target firm. C. It mitigates the effects of undervaluation of the target firm. D. It avoids dilution of shares.

103. Which one of the following statements is correct for a firm that has undergone a leveraged buyout? A. Its shares are no longer traded publicly. B. Its capital is mostly equity financed. C. Its shares are not traded publicly. D. It has a larger shareholder base. 104. Empirical studies show that the operating efficiency of firms having undergone a leverage buyout ______ over the following 3 years. A. increases B. decreases C. does not change D. shows no clear trend

Chapter 21 Test bank - Static Key 1.

When a firm is taken over, its management is usually replaced. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Motives for mergers and acquisitions

Takeovers are often described as part of a broader market for corporate control. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Motives for mergers and acquisitions

A vertical merger is one between firms at different levels of the production process. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

Instead of selling part of its operations, companies sometimes spin off a business by separating it from the parent firm and distributing to its shareholders the stock in the newly independent company. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Divestitures and restructurings

Allergan’s sale of its generic drug business to Teva Pharmaceutical was an example of a divestiture. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember

Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Divestitures and restructurings

Carve-outs and spin-offs both provide shares of the new firm to the divesting firm's shareholders. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Divestitures and restructurings

If a segment of a business is unrelated to the rest of the firm's activities, that segment is more likely to be spun off or carved out. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Divestitures and restructurings

Changing management is the only reason that firms make acquisitions. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

A merger must have the approval of at least 51% of the shareholders of each firm. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Mergers, acquisitions, and divestitures

10.

The expected savings from merging two banks often come from consolidating operations and eliminating redundant costs. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy

Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

11.

A conglomerate merger is defined as the merger of two or more Fortune 500 companies. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

12.

It is always more efficient to integrate vertically than to outsource part of one’s business. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Mergers, acquisitions, and divestitures

13.

By offering to buy shares directly from a target’s shareholders, the acquiring firm can bypass the target firm's management altogether. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

14.

Vertical integration makes sense when two firms are highly dependent upon each other. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

15.

Evidence shows that investors will generally pay a premium for diversified firms. That is a good reason for firms to merge. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic

Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

16.

Synergy is equal to the value of a combined firm minus the total value of the firms prior to merger. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

17.

Target firms frequently deter potential bidders by devising poison pills, which make the company unappetizing. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-04 Describe takeover defenses. Topic: Defensive tactics

18.

Strictly speaking, the purchase of the stock or assets of another firm is an acquisition. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

19.

A typical poison pill may give existing shareholders the right to buy the company's shares at half price as soon as a bidder acquires more than 15% of the shares. The bidder is not entitled to the discount. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-04 Describe takeover defenses. Topic: Defensive tactics

20.

Firm A's shareholders will be better off with a stock offer than with a cash offer if A makes too generous of an offer for Firm B. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic

Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Topic: Merger and acquisition analysis

21.

The Williams Act in addition to state laws sets forth the rules for tender offers. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

22.

Economies of vertical integration are one possible source of synergy in mergers. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

23.

Contrary to logic, firms that enjoy complementary resources in the production process are rarely good candidates for merger. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

24.

An economic gain is derived from mergers when two firms are worth more combined than separate. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

25.

Amendments to the corporate charter that attempt to circumvent mergers are known as poison pills. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic

Learning Objective: 21-04 Describe takeover defenses. Topic: Defensive tactics

26.

On average, stockholders in target firms earn higher returns from mergers than the acquiring firm's stockholders. TRUE

AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Topic: Merger and acquisition analysis

27.

If investors believe a firm may be acquired, its market value is likely to be higher than its stand-alone value. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

28.

Management buyouts are generally all-equity financed by the new shareholders. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-05 Explain some of the motivations for leveraged and management buyouts. Topic: Mergers, acquisitions, and divestitures

29.

Cross-border mergers are often motivated by tax considerations. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

30.

Tax inversion refers to the fact that mergers often result in extra capital gains taxes for shareholders. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Merger and acquisition analysis

31.

One motive for acquiring a firm is to stop wastage of the target firm's cash reserves. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

32.

The 1980s were a time of little merger activity. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

33.

In general, shareholders of the target firm benefit from takeovers. TRUE

34.

Leveraged buyouts are acquisitions where a large fraction of the purchase price is financed with debt. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

35.

The value of the target firm's bonds tend to decrease when a leveraged buyout is announced. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

36.

The free-cash-flow theory supports the notion that the market gain from an LBO is basically the present value of the firm's future cash flows that would otherwise have been wasted. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

37.

Only the U.S. has antitrust laws that can affect mergers and acquisitions. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Mergers, acquisitions, and divestitures

38.

In a merger the acquiring firm buys only the debt of the target firm. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

39.

It is easier for individual investors to diversify their risk by buying shares in different firms than for the firms to combine their operations. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Mergers, acquisitions, and divestitures

40.

In mergers financed by cash, the merger cost is not affected by the size of the merger gain. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

41.

When shareholders attempt to garner additional votes in an attempt to oust management, it is called a: A. management buyout. B. tender offer. C. proxy contest. D. poison pill. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

42.

When one firm merges with another, the: A. boards of directors will merge also. B. merger must be approved by 75% of the shareholders of the target firm. C. assets will be merged but the liabilities will not. D. target firm will cease to exist as a separate public company. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

43.

A tender offer is one in which the firm's: A. management offers to sell the company to an acquirer. B. board of directors offers to sell the company to the public. C. shareholders are given the opportunity to sell their shares to a would-be acquirer. D. management offers to buy all outstanding shares of the corporation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

44.

When an outside group acquires a firm, primarily through the use of borrowed funds, the acquisition is known as a: A. management buyout. B. tender offer. C. leveraged buyout. D. successful proxy fight. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

45.

When a firm's management takes the firm private with the aid of substantial debt, it is known as a management: A. tender offer. B. greenmail offer. C. buyout. D. hostile takeover. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

46.

A spinoff is an action in which: A. the management bids for and acquires the firm. B. one firm issues stock to acquire another firm. C. successful product lines are sold to competitors. D. a portion of the firm's assets is sold off to form a new company. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

47.

If an automobile manufacturer were to acquire one of the firms listed below, which acquisition would be called a horizontal merger? A. A steel mill B. A rival manufacturer C. A tire producer D. A bank AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

48.

If Snapper Lawnmowers were to acquire Briggs and Stratton (gasoline-powered engines), the merger would be classified as a: A. conglomerate. B. leveraged buyout. C. horizontal merger. D. vertical merger. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

49.

A conglomerate merger occurs when: A. both partners are large in size. B. large synergies are expected to develop. C. firms from different industries merge. D. both management teams remain intact after the merger. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

50.

Mergers may provide reductions in average production cost as a result of: A. increased market price. B. increased financing. C. economies of scale. D. diversification. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

51.

Which one of the following might you recommend to a firm with excessive free cash flow? A. Acquire a firm to diversify B. Acquire a firm to bootstrap earnings C. A leveraged buyout D. A repurchase of shares AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

52.

Diversification is often a poor motive for mergers because: A. vertical integration is rarely successful. B. investors can diversify on their own account. C. it does not produce economies of scale. D. the increase in taxes overcomes any gains in earnings. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

53.

One indication that investors expect no synergy from a merger would be that the: A. total market value of the merged firms does not change. B. P/E ratio of the merged firms' changes. C. acquiring firm financed the merger with cash. D. merged firms are from different industries. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

54.

An increase in earnings per share may be increased by a merger if the: A. number of shares has increased. B. price of the acquirer's stock increases. C. acquirer’s P/E ratio is higher than that of the target. D. firm's additional earnings are spent on legal expenses of the merger. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

55.

The cost of a merger may outweigh the potential gain if the: A. present value of the acquired firm exceeds the price paid for it. B. present value of the merged firms is greater than the sum of their individual values. C. merger allows cost savings to occur. D. acquired firm's shareholders receive more than the value of their firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

56.

Firm B's 1 million shares of stock currently sell for $12 each, but firm A is preparing a tender offer of $18 per share. Firm A estimates the NPV of the merger to be $5 million. What percentage of the merger gains will be captured by firm B's stockholders? A. 33.33% B. 50.00% C. 66.67% D. 54.55% Firm B % of gain = [($18 − $12) × 1m] / {[($18 − 12) × 1m] + $5m} = 0.5455, or 54.55%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Topic: Merger and acquisition analysis

57.

The cost of a merger equals the: A. cash paid for the target firm. B. increase in total earnings minus the price paid. C. premium paid over the target's value as a separate entity. D. sum of cash and stock paid for the target firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

58.

ABC Corp. has offered 1 million shares having a total market value of $8 million for XYZ. After the merger is announced, shares in ABC trade for $7 each. If ABC is confident about XYZ's value, then the cost of the merger: A. increased by $1 million. B. decreased by $1 million. C. increased by $9 million. D. remained constant. Preannouncement: Cost of merger = ($8 × 1m) − Value of acquired firm Post announcement: Cost of merger = ($7 × 1m) − Value of acquired firm Difference = ($7 − 8) × 1m = −$1m Since the value of XYZ is assumed constant, the cost of the merger has decreased by $1 million.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

59.

In the case of a merger that is stock financed, the merger cost may change if the: A. value of the target firm's shares changes after the merger announcement. B. value of the acquiring firm's shares changes after the merger announcement. C. long-term interest rates increase. D. merger is either horizontal or vertical. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

60.

The shareholders of firm A have offered 1 million shares valued at $10 each to acquire firm B. After the merger is announced, stock A trades for $9 per share. Which of the following statements is false? A. Firm A appears to have overbid for firm B. B. The NPV of the merger may differ from expectations. C. Shareholders of firm A absorb all the additional "cost." D. Firm A's stockholders are better off than if the merger were cash financed for $10 million. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

61.

Large-scale efforts to make a firm less appealing in the midst of a potential merger are known as: A. proxy fights. B. leveraged buyouts. C. shark attractants. D. poison pills. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-04 Describe takeover defenses. Topic: Defensive tactics

62.

Other things equal, which one of the following groups of stakeholders often lose value as a result of an LBO? A. Selling stockholders B. Buying stockholders C. Pre-LBO bondholders D. Investment bankers AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

63.

The free-cash-flow theory of takeovers predicts that firms: A. without free cash flow will become the most common LBOs. B. with free cash flow will continue to be the acquirers. C. with excess cash do not have a tendency to use it wisely. D. with excess cash tend to have the most carve-outs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

64.

A change to the corporate charter that requires that any merger must be approved by a supermajority of shareholders is known as: A. an LBO. B. a proxy contest. C. a carve-out. D. a shark-repellent. AACSB: Communication

Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-04 Describe takeover defenses. Topic: Defensive tactics

65.

Which of the following is not a mechanism for changing a firm’s management? A. A proxy contest B. A leveraged buyout C. A poison pill D. A takeover AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Shareholder voting

66.

Proxy fights generally occur when a group is trying to: A. rewrite the corporate charter. B. bring about economies of scale. C. replace the current board and management team. D. pursue a public tender offer. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Shareholder voting

67.

One of the reasons why proxy fights are often unsuccessful is that: A. management is always viewed as performing its job well. B. management can use corporate resources to defend against the fight. C. mergers are a cheaper form of changing management. D. shareholders are unconcerned with corporate management. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Shareholder voting

68.

Which one of the following is false concerning a proposed merger of firms? A. The acquired firm will cease to exist. B. Shareholders of the acquired firm may receive securities in the acquiring firm. C. Mergers are sometimes combinations of equals. D. Shareholder approval to merge is not required. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

69.

A public offer to purchase the shares of existing stockholders in order to take the firm over is called a: A. tender offer. B. carve-out. C. spin-off. D. divestiture. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

70.

When a management team buys the firm from current shareholders while continuing to manage and often incurring large segments of debt, it is known as a: A. management buyout. B. spin-off. C. successful greenmail attempt. D. corporate breakup. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Types of mergers and acquisitions

71.

If Georgia Pacific (lumber products) were to acquire a national homebuilding firm, the combination would be termed a: A. horizontal merger. B. vertical merger. C. conglomerate merger. D. spin-off by the national homebuilding firm. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management.

Topic: Types of mergers and acquisitions

72.

Which one of the following is least likely to provide a motivation for vertical integration? A. A continuous source of raw materials B. A desire to spread fixed costs across more output C. Access to an efficient distribution channel D. Acquisition of an established customer base AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Types of mergers and acquisitions

73.

Cash-rich firms often make questionable acquisitions, rather than pay out the cash to shareholders. This: A. is because diversification is too costly for individuals. B. is an example of an agency problem. C. is because diversification eliminates inefficiencies. D. is an example of the bootstrap game. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

74.

Firms with substantial amounts of free cash flow often discover that: A. conglomerate mergers are the best use for the funds. B. accounting profits are what truly matter. C. they have become takeover targets. D. their capital budgets have been too low. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

75.

The "Bootstrap Game" is played somewhat in defiance of traditional merger logic in that it: A. provides immediate benefit through improved management. B. does not offer a positive NPV from the merger. C. stays in effect only until EPS are increased. D. does not require the approval of a majority of shareholders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic

Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Motives for mergers and acquisitions

76.

Mergers that attempt to bootstrap earnings may obtain increased current earnings per share at the expense of: A. a higher price-earnings ratio. B. higher total combined market value. C. reduced future growth prospects. D. increased free cash flow. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

77.

Firms that are acquired to take advantage of bootstrapping often have: A. a lower price-earnings ratio than the acquirer. B. a higher price-earnings ratio than the acquirer. C. more outstanding shares than the acquirer. D. a higher market valuation than the acquirer. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

78.

If two merged firms are shown to have a higher combined market value than the sum of their individual market values, then: A. there are economic gains. B. the firms were previously underpriced. C. the merger provides diversification to investors. D. there is no cost involved in the merger. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

79.

If the shareholders of an acquired firm capture all of the merger's gain, then the: A. cost of the merger is zero. B. NPV of the merger is zero. C. EPS will increase. D. acquiring firm retains all merger benefits. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium

Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

80.

Why is it not sufficient to state that a merger should occur simply because the economic gains are positive? A. Gains are typically of an accounting nature. B. Shareholders of the target firm may capture all of the gains. C. Merger costs should be negative after discounting. D. The merger's gain must also exceed its NPV. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

81.

Firms A and B were each currently worth $50 million but generated a $20 million gain when merged. If the cost of the merger was $5 million, how much did firm A pay for firm B? A. $50 million B. $55 million C. $60 million D. $65 million Cash paid = $50m + 5m = $55m

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

82.

When two firms merge, the value of the acquiring firm will change by the: A. gain from the merger. B. NPV minus the cost of the merger. C. NPV of the merger. D. cost of the merger. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

83.

CBA Corp. is worth $15 million as a stand-alone firm. ABC Corp. has offered 350,000 shares valued at $50 each to acquire CBA. After the announcement, however, the price of ABC's shares falls to $45. What was the cost of the merger? A. −$1.75 million B. $0.75 million C. $1.75 million D. $3.25 million Cost = (350,000 × $45) − $15 million = $0.75 million

84.

Which one of the following statements is correct concerning the cost of two firms merging? The cost: A. is fixed when the merger is financed with cash. B. can be affected by postmerger gains if cash is used. C. decreases as the postmerger share price increases when stock is used to finance the merger. D. is not determined until after the merger, regardless of the type of financing. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

85.

Why might shareholders of an acquiring firm prefer to finance mergers with stock rather than with cash? A. Stock financing is always less costly due to tax consequences. B. The EPS decreases when mergers are financed with cash. C. Target-firm shareholders will bear part of the cost if merger benefits were overestimated. D. All merger gains go to the acquirer when financed with stock. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

86.

Realizing the benefits of a merger is easier when the merging companies have differing: A. computer systems. B. pay structures. C. resources. D. company cultures. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

87.

The most likely interpretation of headlines that read "ABC Corp. adopts shark repellent" is that ABC: A. wants to increase the difficulty of a takeover. B. has made a tender offer for the shares of another firm. C. will merge only with small-sized partners. D. desires to reduce the costs of being acquired. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-04 Describe takeover defenses. Topic: Defensive tactics

88.

Shares of a corporation can, under certain circumstances, be priced at different amounts to different investors under the terms of a: A. proxy agreement. B. public tender offer. C. poison pill. D. shark repellent. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-04 Describe takeover defenses. Topic: Defensive tactics

89.

What does empirical evidence suggest about the distribution of gains from mergers? A. Shareholders of the acquired firm gain the most. B. Shareholders of the acquiring firm gain the most. C. Neither group of shareholders is likely to gain. D. Both groups of shareholders gain equally.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Topic: Real-world studies of mergers and acquisitions

90.

What type of financing is typically instrumental in bringing about leveraged buyouts? A. Common-stock financing B. Preferred-stock financing C. Investment-grade bonds D. Speculative-grade bonds AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Types of mergers and acquisitions

91.

According to the free-cash-flow theory of takeovers, many acquisitions are motivated by: A. an illogical assessment of earnings prospects. B. the remaining costs of the merger. C. the belief that free cash flow will no longer be misused. D. losses experienced by arbitrageurs and other speculators. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

92.

Firm B's 1 million shares of stock currently sell for $20 each. Firm A estimates the economic gain from the merger to be $10 million and is prepared to offer $22 cash for each share of B. What percentage of the merger gain will be captured by firm B's shareholders? A. 20.00% B. 33.33% C. 50.00% D. 60.00% B's % of the gain = [($22 − 20) × 1m] / $10 million = 0.20, or 20%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Topic: Merger and acquisition analysis

93.

XYZ Corp has made a cash tender offer for 2 million shares of ABC Corp. at a price of $20, which is $6 higher than ABC's current stand-alone value. What is the cost of the merger? A. $40 million B. $28 million C. $12 million D. Zero $6 × 2m = $12m

94.

A merger is expected to produce cost savings of $50 million and the acquired firm's shareholders will receive a premium of 20% over the $150 million value of their firm. The gain of the merger to the acquirer is: A. $20 million. B. $30 million. C. $50 million. D. $130 million. GainA = $50 million − ($0.20 × $150m) = $20m

95.

Which one of the following is not a method of changing the management of a firm? A. Proxy contest B. Merger and acquisition C. LBO D. MBO AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Mergers, acquisitions, and divestitures

96.

Which one of the following is correct concerning a spin-off? A. A division of a firm is reconstituted as a new firm. B. An unprofitable division is divested. C. A division of a firm is bought by its managers. D. The spin-off generates no free cash flow. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Divestitures and restructurings

97.

Splitting one firm into four separate firms is an example of a: A. leveraged buyout. B. spin-off. C. management buyout. D. tender offer. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Divestitures and restructurings

98.

The merger between Uptown Bank and Downtown Bank is an example of a: A. vertical merger. B. horizontal merger. C. conglomerate merger. D. direct merger. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

99.

If Microsoft were to acquire Dell Computer, it would be an example of a: A. vertical merger. B. horizontal merger. C. conglomerate merger. D. distribution-channel merger. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

100.

Conglomerate mergers involve companies in: A. similar lines of business. B. different stages of the corporate life cycle. C. unrelated lines of business. D. different countries. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Types of mergers and acquisitions

101.

A merger adds value by creating synergies. Which one of these is not a possible source of synergy? A. Economies of scale B. Economies of vertical integration C. Combined complementary resources D. Diversification AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-01 Explain why it may make sense for companies to merge. Topic: Merger and acquisition analysis

102.

Which one of the following is the most appropriate reason for an acquiring firm's shareholders to prefer using stock financing for acquisitions? A. There is no cash outflow. B. It mitigates the effects of overvaluation of the target firm. C. It mitigates the effects of undervaluation of the target firm. D. It avoids dilution of shares. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm. Topic: Merger and acquisition analysis

103.

Which one of the following statements is correct for a firm that has undergone a leveraged buyout? A. Its shares are no longer traded publicly. B. Its capital is mostly equity financed. C. Its shares are not traded publicly. D. It has a larger shareholder base. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic

Learning Objective: 21-03 Describe ways that companies change their ownership or management. Topic: Types of mergers and acquisitions

104.

Empirical studies show that the operating efficiency of firms having undergone a leverage buyout ______ over the following 3 years. A. increases B. decreases C. does not change D. shows no clear trend

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms. Topic: Real-world studies of mergers and acquisitions

Chapter 21 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

104

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

104

Learning Objective: 21-01 Explain why it may make sense for companies to merge.

Learning Objective: 21-02 Estimate the gains and costs of mergers to the acquiring firm.

Learning Objective: 21-03 Describe ways that companies change their ownership or management.

Learning Objective: 21-04 Describe takeover defenses.

Learning Objective: 21-05 Explain some of the motivations for leveraged and management buyouts.

Learning Objective: 21-06 Summarize the evidence on whether mergers increase efficiency and on how any gains from mergers are distributed between shareholders of the acquired and acquiring firms.

Topic: Defensive tactics

Topic: Divestitures and restructurings

Topic: Merger and acquisition analysis

Topic: Mergers, acquisitions, and divestitures

Topic: Motives for mergers and acquisitions

Topic: Real-world studies of mergers and acquisitions

Topic: Shareholder voting

Topic: Types of mergers and acquisitions

Chapter 22 Test bank - Static Student: ___________________________________________________________________________

The New York Stock Exchange is one of few markets to have a higher daily volume than the foreign exchange market. True

The direct exchange rate quotes the number of U.S. dollars that can be exchanged for one unit of a foreign currency. True

False

Transaction risk can usually be identified and hedged. True

False

Interest rate parity suggests that it is cheaper to borrow in a currency with a low nominal rate of interest. True

False

The spot rate is $1 = C$1.02. The 3-month forward rate is $1 = C$1.03. The Canadian dollar is selling at a forward premium. True

False

The international Fisher effect states that nominal interest rates should be equal in all countries. True

False

According to interest rate parity, the interest rate differential must be equal to the differential between forward and spot exchange rates. True

False

The number of pesos that can be purchased with one U.S. dollar is referred to as an indirect quote. True

False

A U.S. importer of a Japanese product should sell Japanese yen forward to avoid the risk of an appreciation of the yen. True

False

10. Interest rate parity tells us that the cost of buying yen forward is exactly the same as the cost of borrowing dollars, buying yen in the spot market, and leaving them on yen deposit. True

False

11. Even if a firm neither owes nor is owed foreign currency, it still may be affected by currency fluctuations. True

False

12. You can purchase a futures contract on any currency. True

False

13. The forward exchange rate is the rate for immediate exchange of two currencies. True

False

14. If the yen is trading at a forward discount relative to the dollar, then you'll receive less yen per dollar in the future. True

False

15. Futures contracts offer an alternative way to buy foreign currency forward. True

False

16. If inflation is expected to be higher in the U.S. than in Mexico, then the peso is forecasted to depreciate against the dollar. True

False

17. According to the international Fisher effect, the differences in nominal interest rates across countries reflect the differences in their expected rates of inflation. True

False

18. Forward rates are always equal to the actual future exchange rates. True

False

19. Forward contracts are standardized contracts sold in organized exchanges. True

False

20. The law of one price implies that when converted into the same currency a commodity should sell at the same price in all countries. True

False

21. The nominal interest rate is the difference between the real interest rate and inflation. True

False

22. If the international Fisher effect is valid, then expected real interest rates in all countries should be equal. True

False

23. Buying currency in the forward market is a common method of hedging currency risk. True

False

24. If real interest rates are different across countries, investors will shift their money into countries with high real interest rates. True

False

25. An indirect quote is the rate of one unit of foreign currency expressed in U.S. dollars. True

False

26. If the interest rate in one country increases, then the value of that country's currency increases in the forward market. True

False

27. High inflation rates are usually associated with: A. low nominal interest rates. B. high nominal interest rates. C. high real interest rates. D. low real interest rates. 28. If the international Fisher effect holds, what will be the effect of an increase of a country's nominal interest rates on the country's currency? A. The currency will appreciate. B. The currency will depreciate. C. There will be no significant change in the currency's value. D. The currency will sell at a forward premium. 29. If purchasing power parity holds, what will happen to the currency of a country with high inflation? A. The currency will appreciate. B. The currency will depreciate. C. There will be no significant change in the currency's value. D. The currency will sell at a forward premium. 30. You can value overseas investments using the NPV of the cash flows. Which of the following adjustment is necessary to calculate the NPV? A. Adjust the cost of capital by the forward exchange rate and then discount the foreign cash flows B. Convert the foreign cash flows into domestic currency and use the domestic opportunity cost of capital for discounting C. Use the domestic discount rate to discount the foreign cash flows D. Convert the foreign cash flow into domestic currency and use the foreign cost of capital for discounting 31. If the exchange rate of euros/U.S. dollars is USD1.351 = EUR1, then: A. it takes 1.35 euros to buy one US dollar. B. the euro is worth less than one U.S. dollar. C. one dollar is worth approximately €.74. D. one dollar is worth approximately €1. 32. How many dollars will it take for a U.S. citizen to purchase a Japanese product priced at 60,000 yen if the indirect exchange rate is JPY104 = USD1? A. $577 B. $700 C. $5,769 D. $62,400

33. Country A has a higher inflation rate than Country B. In this case Country A will have the: A. a depreciating currency. B. higher nominal interest rate. C. an appreciating currency. D. higher real interest rate. 34. A sandwich costs $6.79 in the U.S. The exchange rate is CAD0.98 = USD1 dollar. What does the identical sandwich have to cost in Canada for the law of one price to exist? A. C$6.93 B. C$6.79 C. C$6.65 D. C$6.86 35. Suppose the spot rate for the Canadian dollar is CAD1.034 = USD1, the 3-month forward rate is CAD1.036 = USD1, and the 1year forward rate is CADS1.039. = USD1. If no other information is available, what will be your guess about the spot rate in 1 year? A. 1.034 B. 1.036 C. 1.039 D. 1.037 36. Suppose that the spot exchange rates against the US dollar are: SEK9.3924 = USD1 CHF1.5231 = USD1 JPY123.380 = USD1 What rate do you think a Japanese bank would quote for exchanging Swiss francs into Swedish krone? A. SEK6.167 = CHF1 B. SEK0.162 = CHF1 C. SEK13.136 = CHF1 D. SEK1 = CHF1

37. Suppose that a bank quotes the following rates: JPY 58.00 = CHF1 CHF1.52 = USD1 JPY123.38 = USD1 Which of the following transactions would produce an arbitrage profit for a US investor? A. Buy 123.38 yen, exchange them for Swiss francs and sell the Swiss francs that you receive. B. Buy 1.52 Swiss francs, exchange them for Japanese yen and sell the yen that you receive. C. Buy both Japanese yen and Swiss francs. D. There are no transactions that would not involve at least some risk. 38. Suppose the 1-year interest rate in Canada is 4% while it is 3% in the U.S. The indirect spot rate is CAD1.02 = USD1. What is the indirect 1-year forward rate? A. CAD1.0299 = USD1 B. CAD1.0608 = USD1 C. CAD1.0200 = USD1 D. CAD1.0302 = USD1 39. If the direct exchange rate between U.S. dollars and pounds sterling is USD1.50 = GBP1, how much should you be willing to pay to receive £350? A. $175.00 B. $233.33 C. $367.50 D. $525.00 40. The main purpose in contracting to purchase foreign currency in the forward market is to: A. earn a premium on the exchange. B. lock into a future currency price now. C. take advantage of future price reductions. D. avoid the more expensive spot rates. 41. Which one of the following is correct if you have contracted to purchase 1,000 Swiss francs 3 months forward at a rate of CHF1.6 = USD1? A. You pay $625 today for the francs. B. You pay $1,600 today for the francs. C. You pay $625 three months from now for the francs. D. You pay $1,600 three months from now for the francs.

42. If the spot exchange rate of Mexican pesos for U.S. dollars is MXN9.8=USD1 and the peso is trading at a forward premium of 3%, then you will receive: A. more than 9.8 pesos per dollar in the future. B. less than 9.8 pesos per dollar in the future. C. 9.83 pesos per dollar in the future. D. 10.09 pesos per dollar in the future. 43. If the spot exchange rate between euros and dollars is USD1.1=EUR1 before the dollar depreciates by 10%, how many dollars will it take after the depreciation has occurred to pay an invoice of €500? A. $550 B. $611 C. $500 D. $345 44. The theory that, when measured in a common currency, the price of a product should be the same in two countries is referred to as the law of: A. exchange rates. B. large numbers. C. spot rates. D. one price. 45. If prices in the United States rise less rapidly than in Canada, which of the following would be expected according to purchasing power parity? A. The value of the Canadian dollar will decline, relative to the U.S. dollar. B. The value of the U.S. dollar will decline, relative to the Canadian dollar. C. Inflation in the U.S. will exceed inflation in Canada. D. The exchange rate will be unaffected by the price changes. 46. If exchange rates adjust to reflect inflation differentials across countries, then: A. the law of one price is wrong. B. spot and forward rates will be equal. C. nominal interest rates will be equal across countries. D. purchasing power parity holds. 47. Suppose that inflation next year is 8% in Japan and 4% in the United States. If the current spot rate is JPY107 = USD1, what is the expected spot rate at the end of the year? A. JPY102.72 = USD1 B. JPY103.04 = USD1 C. JPY111.12 = USD1 D. JPY111.82 = USD1

48. The pound is expected to appreciate by 2% against the dollar. If the expected inflation rate in the United States is 5% and purchasing power parity holds, what is the expected inflation rate in the United Kingdom? A. 1.3% B. 2.9% C. 4.1% D. 7.0% 49. Which one of the following is more likely to be roughly equal across countries? A. Nominal interest rates B. Real interest rates C. Inflation rates D. Forward premium 50. The international Fisher effect predicts that differences in nominal interest rates between countries reflect differences in: A. real rates of interest. B. purchasing power parity. C. the standard of living. D. expected inflation. 51. Expected inflation in the United States is 6%. What do you expect to happen to prices in Japan, if the nominal interest rate is 10% in the United States and 6% in Japan? A. Expected Japanese inflation is 1.79%. B. Expected Japanese inflation is 2.15%. C. Expected Japanese inflation is 6.22%. D. Expected Japanese inflation is 10.00%. 52. Suppose the one-year interest rate in the United States is 7%. What would you expect the interest rate to be in the UK if expected inflation is 4% in the United States and 8% in the UK? A. 5.19% B. 7.93% C. 9.08% D. 11.12% 53. You exchange USD100,000 into Hong Kong dollars today at HKD7.8= USD1, earn 7% on your Hong Kong investment, and exchange back into US dollars at a rate of HKD8.0 = USD1. How much wealthier are you as a result? A. $2,600 B. $4,325 C. $6,000 D. $9,744 54. If a country’s currency trades at a forward premium, interest rate parity would predict that: A. that country will have the higher interest rate. B. that country will have the lower interest rate. C. the two countries will have the same interest rate. D. that country could have a higher or lower interest rate.

55. Which one of the following is advised when evaluating a capital project in a foreign country if you are concerned about political risk? A. The project should be abandoned until this risk disappears. B. The project's cost of capital rate should be decreased to offset the perceived risk. C. The domestic discount rate should be increased to account for the added risk. D. The project cash flows should be decreased to recognize the possibility of bad outcomes. 56. Current 1-year interest rates are 4% and 8% in the United States and Spain, respectively. The anticipated inflation in the United States is 2%. If the international Fisher effect holds, what is the expected inflation rate in Spain? A. 4.00% B. 4.04% C. 5.92% D. 6.00% 57. If you buy yen forward when the yen is selling at a forward premium, you will get: A. more yen than if you buy yen today on the spot market. B. fewer yen than if you buy yen today on spot market. C. the same number of yen as on the spot market, but with a lower commission. D. the expectation of more yen, but the difference is not locked in. 58. According to the expectations theory of exchange rates, what change is expected in the future spot exchange rate if the forward rate trades at an 8% discount? A. The spot rate is expected to appreciate by 8%. B. The spot rate is expected to depreciate by 8%. C. The spot rate is expected to depreciate by 4%. D. No change is expected in the spot rate. 59. If interest rates are higher in Italy than in the United States, US investors can earn a higher expected return by investing in Italian bonds unless the euro is expected to: A. appreciate against the dollar. B. depreciate against the dollar. C. offer a higher real rate of return than the dollar. D. offer a lower real rate of return than the dollar. 60. You are importing TV sets worth ¥10 million from a Japanese manufacturer, and this amount is payable after 6 months. You can hedge your exchange risk by: A. buying Japanese yen in the forward market. B. selling Japanese yen in the forward market. C. borrowing Japanese yen. D. doing nothing – it is impossible to hedge.

61. Buckingham plc, a British corporation, owes $1 million due in 2 months. How can Buckingham hedge the exchange risk? A. Sell pounds in the spot market B. Buy pounds in the forward market C. Sell dollars in the spot market D. Buy dollars in the forward market 62. A firm must make a large future payment in a foreign currency and wants to hedge the associated exchange rate risk. Which one of the following identifies the cost of such a hedge? A. difference between expected and current spot rates B. difference between expected and current forward rates C. difference between the forward premium and the forward discount D. difference between the forward rate and the expected future spot rate 63. An indirect exchange rate can be converted to a direct exchange rate by: A. dividing the indirect rate by the number of U.S. dollars required to purchase one unit of the other currency. B. dividing the indirect rate by 100. C. multiplying the indirect rate by the spot rate. D. taking the inverse of the indirect rate. 64. Yesterday the spot exchange rate of yen-to-dollar was JPY105 = USD1. What is today's spot exchange rate if the yen has appreciated 10% against the dollar today? A. JPY94.5 = USD1 B. JPY95.5 = USD1 C. JPY116.7 = USD1 D. JPY105 = USD1 65. Which one of the following is correct when foreign currency is bought in the forward market? A. A fixed amount is paid when initiating the contract. B. A fixed amount is paid at the end of the contract. C. The amount to be paid is determined and paid at the end of the contract. D. The amount to be paid is determined periodically and paid in installments during the contract. 66. Which one of these is an example of operational hedging? A. Producing goods in a foreign country for sale in the U.S B. Manufacturing goods in the country where they will be sold C. Producing products in one location and distributing them internationally D. Offsetting every spot trade with an opposing forward trade 67. Today, you purchased 125,000 yen 6-months forward at JPY130 = USD1 per dollar. The spot rate today is JPY128 =USD1. If the yen appreciates by 10% over the next six months, how many dollars must you pay to acquire the 125,000 yen? A. $0 B. $961.54 C. $976.56 D. $1,085.07

68. Which of the following is correct when contracting ahead in the forward exchange market? A. At contract close you pay either the forward rate that was contracted or the then-current rate. B. Contracting ahead is always cheaper than waiting to pay spot rates. C. Your cost is locked in from the beginning of the contract, regardless of market changes. D. Paying the spot price is safer than contracting forward. 69. Consider the following spot exchange rates for the British pound, the Japanese yen, the euro and the Swedish krona: USD1.60 = GBP1, JPY105 = USD1, USD0.625 = EUR1, and SEK6.2 = USD1. If gold sells for $290 per ounce in the United States, which one of the following prices for 1 ounce of gold seems to violate the law of one price? A. £181.25 B. ¥30,450 C. €405 D. kr1,798 70. Assume you can exchange $1 for either C$1.03 or €0.74. How many Canadian dollars can be acquired with one euro? A. C$0.7622 B. C$1.2900 C. C$1.3919 D. C$0.7184 71. According to the theory of purchasing power parity, exchange rates will adjust to offset differences in: A. interest rates across countries. B. forward rates across countries. C. expected inflation rates across countries. D. international Fisher rates. 72. If purchasing power parity holds, what is the expected German inflation rate, if the US expected inflation rate is 3%, the spot exchange rate is USD0.667= EUR1 and the expected spot rate is USD0.625 = EUR1? A. 2.8% B. 7.1% C. 9.9% D. 11.4% 73. What would you expect to occur if the expected rate of inflation in the United States is considerably lower than the expected inflation in Germany? A. The expected spot rate of €/$ will decrease. B. The current spot rate of €/$ will increase. C. The dollar should appreciate against the euro. D. The dollar should depreciate against the euro.

74. What would you expect to be the relationship between real rates of interest in Japan and the United States if inflation is expected to be 3% in Japan and 6% in the United States? A. Japan's real interest rate should be 3% higher than in the United States. B. Japan's real interest rate should be 3% lower than in the United States. C. Japan's real interest rate should be half as high as in the United States. D. Real interest rates should be equal in both countries. 75. If nominal interest rates are 5% in the United States and 8% in Mexico, you should convert the expected cash flows on your Mexican project into US dollars: A. by assuming that the Mexican peso will appreciate by about 3% a year. B. by assuming that the Mexican peso will depreciate by 8% a year. C. by assuming that the dollar will appreciate by 5% a year. D. by assuming that the Mexican peso will depreciate by about 3% a year. 76. You have the opportunity to invest in the United States at 6% or invest in an equally risky Australian investment that offers 20%. This is too good to be true! The current exchange rate is AUD1.65 = USD1. Which one of the following do you suspect about this 1-year investment? A. Expected inflation is higher in the United States. B. The 1-year forward exchange rate is AUD1.8679 = USD1. C. Real interest rates are higher in the United States. D. The Australian dollar is selling forward at an 8.48% premium relative to the dollar. 77. Which one of these is probably the best means of reducing or offsetting political risk? A. Refusing any foreign government assistance in building the infrastructure required for your foreign operations B. Borrowing money in the country in which you have foreign operations to fund those activities C. Manufacturing a complete product in a foreign country using only resources from that country D. Paying for all foreign operations with cash originating in the home country 78. Which one of the following appears to be a safe assumption when there is no difference between the forward and spot exchange rates between two currencies? A. The countries have equal nominal interest rates. B. The spot rate is expected to change. C. Expected inflation is less than the nominal rate. D. Both currencies are selling at a premium relative to the other. 79. What is the expected spot rate for Japanese yen one year from now if the current spot rate is JPY106 = USD1 and the yen is selling 1-year forward at JPY114 = USD1? A. JPY78.9 = USD1 B. JPY98.0 = USD1 C. JPY106.0 = USD1 D. JPY114.0 = USD1

80. The international Fisher effect is valid in the long run because: A. inflation rates are equal in different countries. B. investors will move their money into countries with high real interest rates. C. investors will move their money into countries with high nominal interest rates. D. investors will move their money into countries with low inflation. 81. The spot exchange rate for the Canadian dollar is CAD1.02 = USD1. The 6-month interest rate in the United States is 2.5% and 3.0% in Canada. What is the 6-month forward rate for the Canadian dollar? A. CAD1.005= USD1 B. CAD1.025 = USD1 C. CAD0.985= USD1 D. CAD1.02= USD1 82. One of the drawbacks of using forward contracts to hedge foreign exchange risk from payables is that the: A. transaction costs in the forward market are high. B. forward rates are always lower than spot rates. C. hedged currency could appreciate during the period. D. hedged currency could depreciate during the period. 83. A US firm has a contractual payment of £1 million due in 3 months. Which one of the following actions would incur exchange rate risk? A. Buy pounds now at the current spot rate. B. Buy pounds now at the current spot rate. C. Contract forward today to buy pounds in 3 months. D. Buy pounds today in the futures market. 84. Assume the spot exchange rate for the Swiss franc is CHF0.90 = USD1 and the 1-year forward rate is CHF0.871 = USD1. If the 1-year interest rate in the U.S. is 5%, what is the 1-year interest rate in Switzerland? A. 2.00% B. 1.62% C. 1.50% D. 1.33% 85. What is the cost of hedging a 2 million euro commitment if the spot rate is USD1.60 = EUR1, the forward rate is USD1.55 = EUR1, and the spot rate is not expected to change before payment becomes due? A. $0 B. $25,000 C. $40,323 D. $36,667

86. The 2-year interest rate is 6.0% in Mexico and 3.0% in the USA. An American company forecast that its new plant in Mexico will produce a cash flow of 1.3 million pesos in year 2. If the current spot rate is MXN20.0 = USD1, what is the expected dollar cash flow from the plant in year 2? A. $27.54 million. B. $61,373. C. $63,160. D. $1.26 million. 87. You have estimated the cash flows in pesos from a project in Switzerland and also the dollar-based cost of capital for the project. To compute the project NPV in dollars, you now need to compute the: A. current spot rate only. B. opportunity cost of capital measured in terms of the foreign currency. C. implied forward exchange rate for each year in which the project has cash flows. D. actual spot rates for each year in which the project has cash flows. 88. If managers are worried about the political risks involved in an overseas investment, they should probably adjust: A. the discount rate. B. the projected cash flows. C. both the discount rate and the cash flows. D. the exchange rate. 89. If the direct quote for the euro is USD1.35=EUR1, then the indirect quote for the euro is: A. EUR0.51 = USD1. B. EUR0.74 = USD1. C. EUR0.68 = USD1. D. EUR0.65 = USD1. 90. Assume the current spot price is USD1.62 = GBP1 and the 3-month forward rate is USD1.64 = GBP1. Which one of these statements is correct given these rates? A. The pound is selling at a forward premium relative to the dollar. B. The real interest rate in the U.S. is higher than the real rate in the U.K. C. The dollar is expected to appreciate. D. The dollar is selling at a forward premium relative to the pound. 91. The spot exchange rate for the British pound is USD1.60 = GBP1. The annual inflation rate in the U.S. is 4% compared with 8% in the U.K. What is the anticipated exchange rate at the end of the year if purchasing power parity is valid? A. USD1.54 = GBP1 B. USD1.65 = GBP1 C. USD1.60 = GBP1 D. USD1.63 = GBP1

92. The current 1-year nominal interest in the United States is 7%. If the anticipated inflation for the coming year in the United States is 2.5%, what is the real interest rate in the U.S.? A. 4.21% B. 4.39% C. 4.50% D. 7.18%

Chapter 22 Test bank - Static Key 1.

The New York Stock Exchange is one of few markets to have a higher daily volume than the foreign exchange market. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Foreign exchange markets

The direct exchange rate quotes the number of U.S. dollars that can be exchanged for one unit of a foreign currency. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

The number of pesos that can be purchased with one U.S. dollar is referred to as an indirect quote. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

According to interest rate parity, the interest rate differential must be equal to the differential between forward and spot exchange rates. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Interest rate parity

The international Fisher effect states that nominal interest rates should be equal in all countries. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand

Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

The spot rate is $1 = C$1.02. The 3-month forward rate is $1 = C$1.03. The Canadian dollar is selling at a forward premium. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Spot and forward rates

Interest rate parity suggests that it is cheaper to borrow in a currency with a low nominal rate of interest. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Interest rate parity

Transaction risk can usually be identified and hedged. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

A U.S. importer of a Japanese product should sell Japanese yen forward to avoid the risk of an appreciation of the yen. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

10.

Interest rate parity tells us that the cost of buying yen forward is exactly the same as the cost of borrowing dollars, buying yen in the spot market, and leaving them on yen deposit. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

11.

Even if a firm neither owes nor is owed foreign currency, it still may be affected by currency fluctuations. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

12.

You can purchase a futures contract on any currency. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Foreign exchange markets

13.

The forward exchange rate is the rate for immediate exchange of two currencies. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Spot and forward rates

14.

If the yen is trading at a forward discount relative to the dollar, then you'll receive less yen per dollar in the future. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Spot and forward rates

15.

Futures contracts offer an alternative way to buy foreign currency forward. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk.

Topic: Foreign exchange markets

16.

If inflation is expected to be higher in the U.S. than in Mexico, then the peso is forecasted to depreciate against the dollar. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

17.

According to the international Fisher effect, the differences in nominal interest rates across countries reflect the differences in their expected rates of inflation. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

18.

Forward rates are always equal to the actual future exchange rates. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Spot and forward rates

19.

Forward contracts are standardized contracts sold in organized exchanges. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Foreign exchange markets

20.

The law of one price implies that when converted into the same currency a commodity should sell at the same price in all countries. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates.

Topic: Purchasing power parity

21.

The nominal interest rate is the difference between the real interest rate and inflation. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

22.

If the international Fisher effect is valid, then expected real interest rates in all countries should be equal. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

23.

Buying currency in the forward market is a common method of hedging currency risk. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Hedging with forward contracts

24.

If real interest rates are different across countries, investors will shift their money into countries with high real interest rates. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

25.

An indirect quote is the rate of one unit of foreign currency expressed in U.S. dollars. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

26.

If the interest rate in one country increases, then the value of that country's currency increases in the forward market. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Spot and forward rates

27.

High inflation rates are usually associated with: A. low nominal interest rates. B. high nominal interest rates. C. high real interest rates. D. low real interest rates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

28.

If the international Fisher effect holds, what will be the effect of an increase of a country's nominal interest rates on the country's currency? A. The currency will appreciate. B. The currency will depreciate. C. There will be no significant change in the currency's value. D. The currency will sell at a forward premium. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

29.

If purchasing power parity holds, what will happen to the currency of a country with high inflation? A. The currency will appreciate. B. The currency will depreciate. C. There will be no significant change in the currency's value. D. The currency will sell at a forward premium. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

30.

You can value overseas investments using the NPV of the cash flows. Which of the following adjustment is necessary to calculate the NPV? A. Adjust the cost of capital by the forward exchange rate and then discount the foreign cash flows B. Convert the foreign cash flows into domestic currency and use the domestic opportunity cost of capital for discounting C. Use the domestic discount rate to discount the foreign cash flows D. Convert the foreign cash flow into domestic currency and use the foreign cost of capital for discounting AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Topic: International capital budgeting

31.

If the exchange rate of euros/U.S. dollars is USD1.351 = EUR1, then: A. it takes 1.35 euros to buy one US dollar. B. the euro is worth less than one U.S. dollar. C. one dollar is worth approximately €.74. D. one dollar is worth approximately €1. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

32.

How many dollars will it take for a U.S. citizen to purchase a Japanese product priced at 60,000 yen if the indirect exchange rate is JPY104 = USD1? A. $577 B. $700 C. $5,769 D. $62,400 60,000¥ × ($ / 104¥) = $577

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

33.

Country A has a higher inflation rate than Country B. In this case Country A will have the: A. a depreciating currency. B. higher nominal interest rate. C. an appreciating currency. D. higher real interest rate. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

34.

A sandwich costs $6.79 in the U.S. The exchange rate is CAD0.98 = USD1 dollar. What does the identical sandwich have to cost in Canada for the law of one price to exist? A. C$6.93 B. C$6.79 C. C$6.65 D. C$6.86 $6.79 × (C$0.98 / $1) = C$6.65

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

35.

Suppose the spot rate for the Canadian dollar is CAD1.034 = USD1, the 3-month forward rate is CAD1.036 = USD1, and the 1-year forward rate is CADS1.039. = USD1. If no other information is available, what will be your guess about the spot rate in 1 year? A. 1.034 B. 1.036 C. 1.039 D. 1.037 AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Spot and forward rates

36.

Suppose that the spot exchange rates against the US dollar are: SEK9.3924 = USD1 CHF1.5231 = USD1 JPY123.380 = USD1 What rate do you think a Japanese bank would quote for exchanging Swiss francs into Swedish krone?

A. SEK6.167 = CHF1 B. SEK0.162 = CHF1 C. SEK13.136 = CHF1 D. SEK1 = CHF1 Cross-rate = SEK9.3924 = CHF1.5231 SEK6.167 = CHF1

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

37.

Suppose that a bank quotes the following rates: JPY 58.00 = CHF1 CHF1.52 = USD1 JPY123.38 = USD1 Which of the following transactions would produce an arbitrage profit for a US investor?

A. Buy 123.38 yen, exchange them for Swiss francs and sell the Swiss francs that you receive. B. Buy 1.52 Swiss francs, exchange them for Japanese yen and sell the yen that you receive. C. Buy both Japanese yen and Swiss francs. D. There are no transactions that would not involve at least some risk. $1 buys 123.38 yen, which can be converted into 123.38 / 58.00 = 2.127 francs, which in turn buys 2.127 / 1.52 = $1.40.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze

Difficulty: 3 Hard Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Triangular arbitrage

38.

Suppose the 1-year interest rate in Canada is 4% while it is 3% in the U.S. The indirect spot rate is CAD1.02 = USD1. What is the indirect 1-year forward rate? A. CAD1.0299 = USD1 B. CAD1.0608 = USD1 C. CAD1.0200 = USD1 D. CAD1.0302 = USD1 1-year forward rate = C$1.02 × (1.04 / 1.03) = C$1.0299

39.

If the direct exchange rate between U.S. dollars and pounds sterling is USD1.50 = GBP1, how much should you be willing to pay to receive £350? A. $175.00 B. $233.33 C. $367.50 D. $525.00 ₤350 × 1.50 = $525.00

40.

The main purpose in contracting to purchase foreign currency in the forward market is to: A. earn a premium on the exchange. B. lock into a future currency price now. C. take advantage of future price reductions. D. avoid the more expensive spot rates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Currency Hedging

41.

Which one of the following is correct if you have contracted to purchase 1,000 Swiss francs 3 months forward at a rate of CHF1.6 = USD1? A. You pay $625 today for the francs. B. You pay $1,600 today for the francs. C. You pay $625 three months from now for the francs. D. You pay $1,600 three months from now for the francs. 1,000 / 1.6 = $625

42.

If the spot exchange rate of Mexican pesos for U.S. dollars is MXN9.8=USD1 and the peso is trading at a forward premium of 3%, then you will receive: A. more than 9.8 pesos per dollar in the future. B. less than 9.8 pesos per dollar in the future. C. 9.83 pesos per dollar in the future. D. 10.09 pesos per dollar in the future. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Spot and forward rates

43.

If the spot exchange rate between euros and dollars is USD1.1=EUR1 before the dollar depreciates by 10%, how many dollars will it take after the depreciation has occurred to pay an invoice of €500? A. $550 B. $611 C. $500 D. $345 (500 × 0.1.1) / 0.9 = $611

AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

44.

The theory that, when measured in a common currency, the price of a product should be the same in two countries is referred to as the law of: A. exchange rates. B. large numbers. C. spot rates. D. one price. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

45.

If prices in the United States rise less rapidly than in Canada, which of the following would be expected according to purchasing power parity? A. The value of the Canadian dollar will decline, relative to the U.S. dollar. B. The value of the U.S. dollar will decline, relative to the Canadian dollar. C. Inflation in the U.S. will exceed inflation in Canada. D. The exchange rate will be unaffected by the price changes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

46.

If exchange rates adjust to reflect inflation differentials across countries, then: A. the law of one price is wrong. B. spot and forward rates will be equal. C. nominal interest rates will be equal across countries. D. purchasing power parity holds. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

47.

Suppose that inflation next year is 8% in Japan and 4% in the United States. If the current spot rate is JPY107 = USD1, what is the expected spot rate at the end of the year? A. JPY102.72 = USD1 B. JPY103.04 = USD1 C. JPY111.12 = USD1 D. JPY111.82 = USD1 Expected spot rate = 107 × [1.08 / 1.04)] = JPY111.12 = USD1

48.

The pound is expected to appreciate by 2% against the dollar. If the expected inflation rate in the United States is 5% and purchasing power parity holds, what is the expected inflation rate in the United Kingdom? A. 1.3% B. 2.9% C. 4.1% D. 7.0% 1.02 = 1.05 / (1 + UK inflation). UK inflation= 0.029, or 2.9%

49.

Which one of the following is more likely to be roughly equal across countries? A. Nominal interest rates B. Real interest rates C. Inflation rates D. Forward premium AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

50.

The international Fisher effect predicts that differences in nominal interest rates between countries reflect differences in: A. real rates of interest. B. purchasing power parity. C. the standard of living. D. expected inflation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

51.

Expected inflation in the United States is 6%. What do you expect to happen to prices in Japan, if the nominal interest rate is 10% in the United States and 6% in Japan? A. Expected Japanese inflation is 1.79%. B. Expected Japanese inflation is 2.15%. C. Expected Japanese inflation is 6.22%. D. Expected Japanese inflation is 10.00%. 1.06 / 1.10 = (1 + Japanese inflation) / 1.06. Japanese inflation = 0.0215, or 2.15%

52.

Suppose the one-year interest rate in the United States is 7%. What would you expect the interest rate to be in the UK if expected inflation is 4% in the United States and 8% in the UK? A. 5.19% B. 7.93% C. 9.08% D. 11.12% 1.07 / 1.04 = (1 + r) / 1.08; r = 0.1112, or 11.12%

53.

You exchange USD100,000 into Hong Kong dollars today at HKD7.8= USD1, earn 7% on your Hong Kong investment, and exchange back into US dollars at a rate of HKD8.0 = USD1. How much wealthier are you as a result? A. $2,600 B. $4,325 C. $6,000 D. $9,744 ($100,000 × 7.8 × 1.07 / 8) − $100,000 = $4,325

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

54.

If a country’s currency trades at a forward premium, interest rate parity would predict that: A. that country will have the higher interest rate. B. that country will have the lower interest rate. C. the two countries will have the same interest rate. D. that country could have a higher or lower interest rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Interest rate parity

55.

Which one of the following is advised when evaluating a capital project in a foreign country if you are concerned about political risk? A. The project should be abandoned until this risk disappears. B. The project's cost of capital rate should be decreased to offset the perceived risk. C. The domestic discount rate should be increased to account for the added risk. D. The project cash flows should be decreased to recognize the possibility of bad outcomes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Topic: International capital budgeting

56.

Current 1-year interest rates are 4% and 8% in the United States and Spain, respectively. The anticipated inflation in the United States is 2%. If the international Fisher effect holds, what is the expected inflation rate in Spain? A. 4.00% B. 4.04% C. 5.92% D. 6.00% Inflation in Spain = [1.08 / (1.04 / 1.02)] − 1 = 0.0592, or 5.92%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

57.

If you buy yen forward when the yen is selling at a forward premium, you will get: A. more yen than if you buy yen today on the spot market. B. fewer yen than if you buy yen today on spot market. C. the same number of yen as on the spot market, but with a lower commission. D. the expectation of more yen, but the difference is not locked in. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Spot and forward rates

58.

According to the expectations theory of exchange rates, what change is expected in the future spot exchange rate if the forward rate trades at an 8% discount? A. The spot rate is expected to appreciate by 8%. B. The spot rate is expected to depreciate by 8%. C. The spot rate is expected to depreciate by 4%. D. No change is expected in the spot rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Spot and forward rates

59.

If interest rates are higher in Italy than in the United States, US investors can earn a higher expected return by investing in Italian bonds unless the euro is expected to: A. appreciate against the dollar. B. depreciate against the dollar. C. offer a higher real rate of return than the dollar. D. offer a lower real rate of return than the dollar. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Interest rate parity

60.

You are importing TV sets worth ¥10 million from a Japanese manufacturer, and this amount is payable after 6 months. You can hedge your exchange risk by: A. buying Japanese yen in the forward market. B. selling Japanese yen in the forward market. C. borrowing Japanese yen. D. doing nothing – it is impossible to hedge. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

61.

Buckingham plc, a British corporation, owes $1 million due in 2 months. How can Buckingham hedge the exchange risk? A. Sell pounds in the spot market B. Buy pounds in the forward market C. Sell dollars in the spot market D. Buy dollars in the forward market AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

62.

A firm must make a large future payment in a foreign currency and wants to hedge the associated exchange rate risk. Which one of the following identifies the cost of such a hedge? A. difference between expected and current spot rates B. difference between expected and current forward rates C. difference between the forward premium and the forward discount D. difference between the forward rate and the expected future spot rate AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

63.

An indirect exchange rate can be converted to a direct exchange rate by: A. dividing the indirect rate by the number of U.S. dollars required to purchase one unit of the other currency. B. dividing the indirect rate by 100. C. multiplying the indirect rate by the spot rate. D. taking the inverse of the indirect rate. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

64.

Yesterday the spot exchange rate of yen-to-dollar was JPY105 = USD1. What is today's spot exchange rate if the yen has appreciated 10% against the dollar today? A. JPY94.5 = USD1 B. JPY95.5 = USD1 C. JPY116.7 = USD1 D. JPY105 = USD1 Today's spot rate = 105 × .9 = JPY94.5 = USD1

65.

Which one of the following is correct when foreign currency is bought in the forward market? A. A fixed amount is paid when initiating the contract. B. A fixed amount is paid at the end of the contract. C. The amount to be paid is determined and paid at the end of the contract. D. The amount to be paid is determined periodically and paid in installments during the contract. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Currency Hedging

66.

Which one of these is an example of operational hedging? A. Producing goods in a foreign country for sale in the U.S B. Manufacturing goods in the country where they will be sold C. Producing products in one location and distributing them internationally D. Offsetting every spot trade with an opposing forward trade AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

67.

Today, you purchased 125,000 yen 6-months forward at JPY130 = USD1 per dollar. The spot rate today is JPY128 =USD1. If the yen appreciates by 10% over the next six months, how many dollars must you pay to acquire the 125,000 yen? A. $0 B. $961.54 C. $976.56 D. $1,085.07 Dollar cost = 125,000 / 130 = $961.54

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

68.

Which of the following is correct when contracting ahead in the forward exchange market? A. At contract close you pay either the forward rate that was contracted or the then-current rate. B. Contracting ahead is always cheaper than waiting to pay spot rates. C. Your cost is locked in from the beginning of the contract, regardless of market changes. D. Paying the spot price is safer than contracting forward. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

69.

Consider the following spot exchange rates for the British pound, the Japanese yen, the euro and the Swedish krona: USD1.60 = GBP1, JPY105 = USD1, USD0.625 = EUR1, and SEK6.2 = USD1. If gold sells for $290 per ounce in the United States, which one of the following prices for 1 ounce of gold seems to violate the law of one price? A. £181.25 B. ¥30,450 C. €405 D. kr1,798 £181.25 × 1.60 = $290 ¥30,450 / 105 = $290 €405 × 0.625 = $253.13 violates the law of one price. kr1,798 / 6.2 = $290

70.

Assume you can exchange $1 for either C$1.03 or €0.74. How many Canadian dollars can be acquired with one euro? A. C$0.7622 B. C$1.2900 C. C$1.3919 D. C$0.7184 1.03 / 0.74 = C$1.3919

71.

According to the theory of purchasing power parity, exchange rates will adjust to offset differences in: A. interest rates across countries. B. forward rates across countries. C. expected inflation rates across countries. D. international Fisher rates. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

72.

If purchasing power parity holds, what is the expected German inflation rate, if the US expected inflation rate is 3%, the spot exchange rate is USD0.667= EUR1 and the expected spot rate is USD0.625 = EUR1? A. 2.8% B. 7.1% C. 9.9% D. 11.4% 1 + expected German inflation = 1.03 × 0.667 / 0.625 = 1.099

73.

What would you expect to occur if the expected rate of inflation in the United States is considerably lower than the expected inflation in Germany? A. The expected spot rate of €/$ will decrease. B. The current spot rate of €/$ will increase. C. The dollar should appreciate against the euro. D. The dollar should depreciate against the euro. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

74.

What would you expect to be the relationship between real rates of interest in Japan and the United States if inflation is expected to be 3% in Japan and 6% in the United States? A. Japan's real interest rate should be 3% higher than in the United States. B. Japan's real interest rate should be 3% lower than in the United States. C. Japan's real interest rate should be half as high as in the United States. D. Real interest rates should be equal in both countries. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

75.

If nominal interest rates are 5% in the United States and 8% in Mexico, you should convert the expected cash flows on your Mexican project into US dollars: A. by assuming that the Mexican peso will appreciate by about 3% a year. B. by assuming that the Mexican peso will depreciate by 8% a year. C. by assuming that the dollar will appreciate by 5% a year. D. by assuming that the Mexican peso will depreciate by about 3% a year. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Topic: International capital budgeting

76.

You have the opportunity to invest in the United States at 6% or invest in an equally risky Australian investment that offers 20%. This is too good to be true! The current exchange rate is AUD1.65 = USD1. Which one of the following do you suspect about this 1-year investment? A. Expected inflation is higher in the United States. B. The 1-year forward exchange rate is AUD1.8679 = USD1. C. Real interest rates are higher in the United States. D. The Australian dollar is selling forward at an 8.48% premium relative to the dollar. Forward rate = 1.65 × 1.20 / 1.06. AUD1.8679 = USD1

77.

Which one of these is probably the best means of reducing or offsetting political risk? A. Refusing any foreign government assistance in building the infrastructure required for your foreign operations B. Borrowing money in the country in which you have foreign operations to fund those activities C. Manufacturing a complete product in a foreign country using only resources from that country D. Paying for all foreign operations with cash originating in the home country AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Topic: Political risk

78.

Which one of the following appears to be a safe assumption when there is no difference between the forward and spot exchange rates between two currencies? A. The countries have equal nominal interest rates. B. The spot rate is expected to change. C. Expected inflation is less than the nominal rate. D. Both currencies are selling at a premium relative to the other. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Purchasing power parity

79.

What is the expected spot rate for Japanese yen one year from now if the current spot rate is JPY106 = USD1 and the yen is selling 1-year forward at JPY114 = USD1? A. JPY78.9 = USD1 B. JPY98.0 = USD1 C. JPY106.0 = USD1 D. JPY114.0 = USD1 AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: Spot and forward rates

80.

The international Fisher effect is valid in the long run because: A. inflation rates are equal in different countries. B. investors will move their money into countries with high real interest rates. C. investors will move their money into countries with high nominal interest rates. D. investors will move their money into countries with low inflation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

81.

The spot exchange rate for the Canadian dollar is CAD1.02 = USD1. The 6-month interest rate in the United States is 2.5% and 3.0% in Canada. What is the 6-month forward rate for the Canadian dollar? A. CAD1.005= USD1 B. CAD1.025 = USD1 C. CAD0.985= USD1 D. CAD1.02= USD1 6-month forward rate = 1.02 × (1.03/1.025) = CAD1.025 = USD1

82.

One of the drawbacks of using forward contracts to hedge foreign exchange risk from payables is that the: A. transaction costs in the forward market are high. B. forward rates are always lower than spot rates. C. hedged currency could appreciate during the period. D. hedged currency could depreciate during the period. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

83.

A US firm has a contractual payment of £1 million due in 3 months. Which one of the following actions would incur exchange rate risk?

A. Buy pounds now at the current spot rate. B. Buy pounds in 3 months at the current spot rate. C. Contract forward today to buy pounds in 3 months. D. Buy pounds today in the futures market. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk. Topic: Currency Hedging

84.

Assume the spot exchange rate for the Swiss franc is CHF0.90 = USD1 and the 1-year forward rate is CHF0.871 = USD1. If the 1-year interest rate in the U.S. is 5%, what is the 1-year interest rate in Switzerland? A. 2.00% B. 1.62% C. 1.50% D. 1.33% Swiss interest rate = 1.05 × 0.871 / 0.9 − 1 = 0.0162, or 1.62%

85.

What is the cost of hedging a 2 million euro commitment if the spot rate is USD1.60 = EUR1, the forward rate is USD1.55 = EUR1, and the spot rate is not expected to change before payment becomes due? A. $0 B. $25,000 C. $40,323 D. $36,667 Cost of hedge = cost of buying at the forward price − cost of buying at the expected spot price = 2,000,000 / 1.55 − 2,000,000/ 1.60 = $40,323

86.

The 2-year interest rate is 6.0% in Mexico and 3.0% in the USA. An American company forecast that its new plant in Mexico will produce a cash flow of 1.3 million pesos in year 2. If the current spot rate is MXN20.0 = USD1, what is the expected dollar cash flow from the plant in year 2? A. $27.54 million. B. $61,373. C. $63,160. D. $1.26 million. 2-year forward rate = 20 ×(1.06 / 1.03)2 = MXN21.182 = USD1 Expected cash flow = 1.3 million / 21.182 = $61,373

AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Topic: International capital budgeting

87.

You have estimated the cash flows in pesos from a project in Switzerland and also the dollar-based cost of capital for the project. To compute the project NPV in dollars, you now need to compute the: A. current spot rate only. B. opportunity cost of capital measured in terms of the foreign currency. C. implied forward exchange rate for each year in which the project has cash flows. D. actual spot rates for each year in which the project has cash flows. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Topic: International capital budgeting

88.

If managers are worried about the political risks involved in an overseas investment, they should probably adjust: A. the discount rate. B. the projected cash flows. C. both the discount rate and the cash flows. D. the exchange rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies. Topic: International capital budgeting

89.

If the direct quote for the euro is USD1.35=EUR1, then the indirect quote for the euro is: A. EUR0.51 = USD1. B. EUR0.74 = USD1. C. EUR0.68 = USD1. D. EUR0.65 = USD1. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Exchange rates

90.

Assume the current spot price is USD1.62 = GBP1 and the 3-month forward rate is USD1.64 = GBP1. Which one of these statements is correct given these rates? A. The pound is selling at a forward premium relative to the dollar. B. The real interest rate in the U.S. is higher than the real rate in the U.K. C. The dollar is expected to appreciate. D. The dollar is selling at a forward premium relative to the pound. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-01 Understand the difference between spot and forward exchange rates. Topic: Spot and forward rates

91.

The spot exchange rate for the British pound is USD1.60 = GBP1. The annual inflation rate in the U.S. is 4% compared with 8% in the U.K. What is the anticipated exchange rate at the end of the year if purchasing power parity is valid? A. USD1.54 = GBP1 B. USD1.65 = GBP1 C. USD1.60 = GBP1 D. USD1.63 = GBP1 Expected exchange rate = 1.60 × 1.04 / 1.08 = 1.54

92.

The current 1-year nominal interest in the United States is 7%. If the anticipated inflation for the coming year in the United States is 2.5%, what is the real interest rate in the U.S.? A. 4.21% B. 4.39% C. 4.50% D. 7.18% r = 1.07 / 1.025 − 1 = 0.0439, or 4.39%

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates. Topic: International Fisher effect

Chapter 22 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 22-01 Understand the difference between spot and forward exchange rates.

Learning Objective: 22-02 Understand the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates.

Learning Objective: 22-03 Formulate simple strategies to protect the firm against exchange rate risk.

Learning Objective: 22-04 Perform an NPV analysis for projects with cash flows in foreign currencies.

Topic: Currency Hedging

Topic: Exchange rates

Topic: Foreign exchange markets

Topic: Hedging with forward contracts

Topic: Interest rate parity

Topic: International capital budgeting

Topic: International Fisher effect

Topic: Political risk

Topic: Purchasing power parity

Topic: Spot and forward rates

Topic: Triangular arbitrage

Chapter 23 Test bank - Static Student: ___________________________________________________________________________

The seller of a put option is betting that the market value of the stock will decrease. True

The VIX is an estimate of expected future market volatility. True

False

The Financial Accounting Standards Board (FASB) requires that companies recognize the fact that employee stock options are valuable and therefore are an expense just like salaries and wages. True

False

The value of a call option increases as the exercise price decreases. True

False

A strategy of buying the stock and selling the put is called a protective put. True

False

The lower limit on a call option's value is equal to the greater of zero or the exercise price minus the stock price. True

False

A call option is worthless if the underlying stock is worthless. True

False

The value of both call and put options increases as the variability of the stock price decreases. True

False

10. Callable bonds allow the investor to redeem the bond at face value or let the bond remain outstanding until maturity. True

False

11. Warrants do not expire. True

False

12. Convertible bonds give the investor the option to acquire the firm's stock in exchange for the value of the underlying bond. True

False

13. Callable bonds give the call option to the issuing firm and hence reduce the value of the bond. True

False

14. The longer the time until expiration of a call option, the lower the value of the option. True

False

15. Only at the expiration date can an investor expect to find the value of call options above their lower bound. True

False

16. Stock price volatility is beneficial to option holders. True

False

17. Unlike call options, the option to abandon a real asset can never be more valuable as time to expiration increases. True

False

18. A callable bond gives the issuer a potentially valuable option in the case of changing interest rates. True

False

19. At expiration a call option will have no value if the stock price is less than exercise price. True

False

20. At expiration a put option will have no value if the stock price is less than the exercise price. True

False

21. A protective put is a way to eliminate the downside risk of holding stock. True

False

22. The value of a call option increases as the exercise price increases. True

False

23. When the stock price is very high compared with the exercise price, the value of the call option approximates the difference between the stock price and the present value of the exercise price. True

False

24. Warrants are long-term call options on a company's stock issued by an organized stock exchange. True

False

25. A warrant is a long-term call option that is always "in the money" at the time of issuance. True

False

26. A callable bond will have a lower value than a straight bond with the same coupon rate and maturity. True

False

27. The floor of a convertible bond is the value of the underlying bond. True

False

28. The value of a convertible bond is always less than the value of a straight bond with similar coupon and maturity. True

False

29. The writer of a call option hopes that the stock price will: A. decrease. B. increase. C. split. D. produce quarterly cash dividends. 30. Adding warrants as a "sweetener" to bonds will: A. reduce the value of the bond. B. increase the coupon rate of the bond. C. increase the value of the package. D. make the bond riskier. 31. If you own a call and a put on a stock with the same exercise price and exercise date, your payoffs: A. will be positive only if the stock price rises. B. will be positive only if the stock price declines. C. will always be positive and will increase with the size of the stock price change. D. will always be positive but will be larger if the stock price is relatively stable. 32. Which one of the following is true for the owner of a call option? A. The loss potential is unlimited. B. The profit potential is unlimited. C. The option price exceeds the exercise price. D. There is no expiration date, unless the option is a European call. 33. An increase in which one of the following will reduce the value of a call option? A. Interest rate B. Time to expiration C. Volatility of stock price D. Exercise price

34. What is the difference between an American call option and a European call option? A. The European call has a final exercise date. B. The American call trades only on domestic stocks. C. The European call can be exercised only on one day. D. The American call generates profits regardless of which direction the stock moves. 35. What is the option buyer's total profit or loss per share if a call option is purchased for $5, has a $50 exercise price, and the stock is valued at $53 at expiration? A. −$5 B. −$2 C. $3 D. $8 36. The maximum possible payoff to the owner of a put options is: A. the stock price. B. the exercise price minus the stock price. C. the option’s exercise price. D. there is no maximum. 37. Which one of the following option traders receives the price of the option? A. Option sellers B. Option buyers C. Both option sellers and buyers D. Neither buyers nor sellers receive the price 38. Which one of the following is true for an investor who purchased a share of stock for $45 and purchased a put option on the stock with an exercise price of $45? A. The investor profits when the stock decreases in value. B. The minimum payoff on the position is $45. C. The investor is protected against upside potential. D. Increases in the value of the stock will go to the seller of the put. 39. An investor purchased a share of stock for $42 and at the same time paid $2 to purchase a put option on the stock with an exercise price of $40. What is her profit if the stock is worth $30 at expiration? A. $6 B. −$6 C. −$4 D. $4 40. Which combination of positions will protect the owner from downside risk? A. Buy the stock and buy a call option B. Sell the stock and buy a call option C. Buy the stock and buy a put option D. Buy the stock and sell a put option

41. If you feel strongly that a stock price will move a lot, but are unsure of the direction, you could: A. buy both a put and a call. B. sell both a put and a call. C. buy a put and sell a call. D. buy two puts. 42. A stock is currently selling for $70 per share. What is the lower limit on the value of a call option with an exercise of $90? A. −$20 B. $0 C. $10 D. $20 43. Why does the value of a call option increase as the interest rate increases? A. The stock seller must pay the call owner more interest. B. The present value of the exercise price is reduced. C. As interest rates increase, stock prices increase. D. Interest rate increases reduce the option value. 44. Which of the following statements is true of the holder of a call option? A. Option holders pay no income taxes. B. Holders of a call option have restricted profits. C. Option holders do not receive dividends. D. Investors in call options do not have to exercise them and therefore cannot sustain losses. 45. How much must the stock be worth at expiration in order for the buyer of a call option to break even if the exercise price is $50 and the cost of the call was $4? A. $46 B. $50 C. $52 D. $54 46. What is the most an investor can lose if sells a call on the firm's stock with an exercise price of $100? A. $100 B. $0 C. $50 D. Unlimited losses 47. Which one of the following call options would command the higher price, other things equal? (All months are within the same calendar year.) A. October expiration, $45 exercise price B. December expiration, $40 exercise price C. March expiration, $45 exercise price D. June expiration, $40 exercise price

48. Put-call parity states that: A. Price of stock + price of call = price of put + PV(exercise price) B. Price of stock + PV(exercise price) = price of call + price of put C. Price of stock + price of put = price of call + PV(exercise price) D. Price of stock = price of put + price of call − exercise price 49. Executive stock options are issued with the hope that the recipients will: A. sell the shares they currently own thereby diversifying the firm's ownership. B. work to increase the value of the firm's stock. C. never exercise them. D. sell their shares at the option's exercise price. 50. The major difference between options on real assets and options on financial assets is that options on: A. financial assets are costly. B. financial assets have a higher probability of positive payoff. C. real assets are implicit, rather than explicit. D. real assets are not influenced by price volatility. 51. The option to abandon a project investing in real assets can be considered to have an exercise price equal to the: A. historical cost of the asset. B. resale value of the asset at abandonment. C. foregone revenues anticipated from the project. D. foregone interest on the bonds used to finance the real assets. 52. Investors who hold warrants essentially have a: A. put option on the firm's bonds. B. put option on the firm's equity. C. call option on the firm's bonds. D. call option on the firm's equity. 53. The conversion ratio for a convertible bond equals the: A. number of interest payments that must be received prior to conversion. B. number of bonds necessary to convert into one share of stock. C. number of shares of stock that can be exchanged for one bond. D. floor value beneath which the bond price cannot fall. 54. If a $1,000 convertible bond with a market value of $950 has a conversion ratio of 25 when the firm's stock is selling for $36 per share, then: A. the bond will be converted immediately. B. the bond is violating its price floor. C. conversion now would give the investor a profit of $900. D. the conversion value of the bond is $900.

55. If a $1,000 convertible bond has a conversion ratio of 50 and the firm's equity is currently selling for $22 per share, then the: A. bond should trade for at least $900. B. bond should trade for at least $1,000. C. bond should trade for at least $1,100. D. firm will have already converted the bond. 56. Which one of the following conditions will typically be present when a firm calls a bond prior to maturity? A. The firm is in poor financial health. B. Interest rates have risen substantially since the bond was issued. C. Interest rates have fallen substantially since the bond was issued. D. The call option is about to expire. 57. The value of a callable bond equals the value of a straight bond: A. plus the value of the bondholder's call option. B. minus the value of the bondholder's call option. C. plus the value of the issuer's call option. D. minus the value of the issuer's call option. 58. A 10% convertible bond has a conversion ratio of 25. The firm’s common stock is currently selling at $35. If the bond is about to mature, what is its value? A. $875 B. $1,000 C. $1,125 D. $1,875 59. Which one of the following statements is correct? A. A convertible bond will be worth less than a similar non-convertible bond. B. A callable bond will be worth less than a similar non-callable bond. C. A callable bond will be worth more than a similar convertible bond. D. Warrants are always worth more than convertible bonds. 60. A put and a call both have the same maturity and both have an exercise price which is equal to the current stock price. The interest rate is 5%. Which option should sell for a higher price? A. the put. B. both should sell for the same price. C. the call. D. can’t say without knowing the variability of the stock. 61. Which one of the following is correct for the owner of a June call on XYZ Corp. with an exercise price of $60? XYZ Corp. currently trades at $55 and the option at $3. A. XYZ stock will go to $63 per share within the option period. B. The option should be exercised now. C. The option owner's current profit is $3 per share. D. The option may expire without value.

62. It is May and you own a June call on ABC Corp. with an exercise price of $50. The option trades at $40 and ABC is trading at $86. What should you do? A. Exercise the option now and take the profits. B. Buy the stock of ABC Corp because option traders seem to be optimistic about its prospects. C. Sell your ABC stock before its price declines. D. Sit and wait until the June expiration. 63. At what point does the value of a call option lie furthest above its lower bound (that is, the maximum of zero or the stock price − exercise price)? A. When the stock price is zero. B. When the stock price is very high relative to the exercise price. C. When the stock price equals the exercise price. D. It depends on the maturity of the option. 64. You own a September put on CBA Corp. with an exercise price of $80. CBA stock currently trades at $80 and the put at $5. Which of the following is definitely true? A. The option will continue to gain value until its September expiration. B. The owner should exercise now in order to avoid further losses. C. Decreases in the CBA stock price will be translated directly into additional option value. D. $20 is the maximum value for this option. 65. The buyer of a put option has a(n) _____ to sell the underlying asset and the option seller has a(n) ____ to buy the underlying asset. A. obligation; obligation B. obligation; right C. right; right D. right; obligation 66. Joe sold a put option on ZZZ Corp. with an exercise price of $40. The option is about to expire and ZZZ stock is currently trading at $28 per share. What is the value of Joe’s position? A. $12 B. −$12 C. $8 D. $16 67. Maria sold a call option on XXX Corp. with an exercise price of $50. The option is about to expire and stock XXX is currently trading at $40. What is the value of Maria's position? A. −$10 B. $0 C. $7 D. $10

68. The payoffs from investing in an option contract are designed so that: A. both the buyer and the seller of the contract will profit. B. the seller's (buyer's) gain is the buyer's (seller's) loss. C. roughly 20% of sellers and 50% of buyers profit. D. there are no profits but there are also no losses. 69. Under what circumstance will the buyer of a put option need to fulfill her obligation? A. When the stock price has declined below the exercise price. B. When the stock price has increased above the exercise price. C. The put buyer has an equal obligation regardless of the relationship between stock and exercise prices. D. The put buyer has no obligation. 70. Which one of the following statements is correct for an investor who has purchased portfolio insurance by owning a stock and buying a put option on that stock? A. The investor profits when the stock price declines. B. Maximum profitability occurs when the stock price equals the exercise price. C. The value of the position can decline no further than the option’s exercise price. D. The option will certainly be exercised. 71. A call option will have the highest value when the stock price is: A. far above the exercise price. B. closest to the exercise price. C. approaching zero. D. less than the exercise price. 72. When does a change in the value of a call option come closest to matching the change in the price of the stock? A. When the stock is priced far above the exercise price. B. When the stock is priced far below the exercise price. C. When the stock is priced near zero. D. Changes in call value always come close to matching changes in stock price. 73. At what point is the dollar payoff from owning a call option on a stock greater than the payoff from owning the stock itself? A. When stock price exceeds exercise price at expiration. B. When exercise price exceeds stock price at expiration. C. When stock price equals exercise price at expiration. D. Call payoff never exceeds stock payoff. 74. What is the lower bound on the value of a put option? A. Maximum of zero or exercise price − stock price B. Maximum of zero or stock price − exercise price C. Stock price − exercise price D. Exercise price − stock price

75. The value of a call option increases as the time to expiration increases because: A. the exercise price continually decreases. B. the opportunity increases for the stock price to exceed the exercise price. C. the dividends accumulate while waiting to be paid. D. the option can be repeatedly exercised. 76. Stocks that have more volatile price changes have more valuable call options because call holders: A. capture upside potential without additional downside risk. B. realize that volatility decreases the present value of the exercise price. C. have too little variability in the exercise price. D. have transferred all risk to put holders. 77. Of the following four put options that can be purchased on a stock, which would you expect to have the highest price? (All option months are in the same calendar year.) A. September put; $65 exercise price B. September put; $75 exercise price C. December put; $65 exercise price D. December put; $75 exercise price 78. A share of stock is currently priced at $20 and will change with equal likelihood to either $40 or $10. A call option with a $20 exercise price is available on the stock. The interest rate is zero. Which of the following positions will provide (approximately) the same payoffs as the option? A. Buy 0.667 shares and lend $6.67 B. Buy 0.667 shares and borrow $6.67 C. Buy 0.5 shares D. Sell 0.667 shares and borrow $0.667 79. Which of the following is not a real option? A. If tanker rates fall, the company can lay up its fleet B. The extra warehouse space allows the company to expand C. The company replaces an ageing machine tool D. If oil prices rise the company can switch to using gas 80. Real options are: A. options on real assets such as an option to abandon. B. call and put options traded on organized exchanges. C. call options such as warrants and convertible bonds. D. put options such as those held by shareholders of a firm with financial leverage. 81. Corporations that attach warrants to their bonds are hoping to: A. repurchase shares of outstanding stock. B. convert the bonds into stock at a later date. C. increase the value of the bonds. D. increase the price of their shares.

82. If a convertible bond can be thought of as a straight bond with a call option, then the call is owned by the _____, and the exercise price is the _____. A. debt issuer; stock price B. debt issuer; straight bond value C. bond investor; stock price D. bond investor; straight bond value 83. Why should a convertible bond always be valued at more than its bond value or its conversion value up until maturity? A. The bond holder is receiving higher interest rates. B. The holder can decide later whether to own the bond or the stock. C. The conversion ratio may be decreased. D. The bond does not have to be given up to exercise the option. 84. A 10-year convertible bond has a face value of $1,000, a 9% coupon, and a conversion ratio of 30. The stock is currently priced at $35. If a comparable straight bond would have a yield of 9%, what is the minimum value of the call option provided by the convertible? A. $0 B. $5 C. $50 D. $65 85. Which one of the following is correct? A. There is an upper bound on a callable bond's price. B. Callable bond prices are higher than those of comparable straight bonds. C. The attraction of callable bonds to the issuer increases as interest rates increase. D. The investor in a callable bond owns the call option. 86. The value of a call option at expiration will be equal to the maximum of zero or the: A. stock price. B. exercise price. C. stock price minus the exercise price. D. exercise price minus the stock price. 87. Kingston Lisle shares are currently selling at $75. The value of a call option on the company’s shares with an exercise price of $60 and several months to expiration is: A. less than $15. B. greater than $15. C. equal to $15. D. zero.

88. You purchased a call option with an exercise price of $50. If you exercise the option when the stock price is $60, your proceeds will be: A. $10. B. $0. C. $4. D. $16. 89. Three months ago you bought a put option with an exercise price of $100. What is the value of this option at expiration if the stock price is $110? A. $10 B. −$110 C. $0 D. −$10 90. A firm is planning to issue a callable bond with a coupon rate of 8% and 10 years to maturity. A straight bond with a similar coupon is priced at $1,000. If the value of the issuer's call option is $60, what is the value of the callable bond? A. $940 B. $970 C. $1,000 D. $1,060 91. A stock is selling for $85 at the expiration of an option contract. Which of the following options on the stock will most likely be exercised? A. Call option with exercise price of $65 B. Put option with exercise price of $65 C. Call option with exercise price of $85 D. Put option with exercise price of $85 92. Which one of the following changes will reduce the value of a call option? A. An increase in the stock price B. An increase in the exercise price C. An increase in the volatility of the stock price D. An increase in interest rates 93. An investor who sells a put option profits if: A. stock prices go up. B. stock prices go down. C. the put is exercised. D. interest rates go up.

94. A call option has an exercise price of $60. When the option expires, the price of the stock is exactly $60. What is the value of your call option? A. $1 B. −$1 C. Zero D. $60 95. The value of a put at expiration is defined as the: A. minimum of zero or the stock price minus the exercise price. B. minimum of zero or the exercise price minus the stock price. C. maximum of zero or the stock price minus the exercise price. D. maximum of zero or the exercise price minus the stock price. 96. You purchased a stock for $36 a share, a call option with an exercise price of $35, and a put option with an exercise price of $34. What will be the value of your position when the options expire if the stock price is $37? A. $39 B. $37 C. $40 D. $2 97. You purchased a stock for $43 a share, sold a call option with an exercise price of $40, and bought a put option with an exercise price of $45. What will be the value of your position when the options expire if the stock price is $48 a share? A. $48 B. $46 C. $56 D. $40 98. You purchased a stock and a put option on the stock with an exercise prices of $40 a share. What will be the value of your position when the option expires if the stock price is $28 a share? A. $40 B. $28 C. $12 D. $32 99. If you sell a put option, your maximum payoff is equal to: A. The maximum of zero or the stock price − the exercise price. B. The maximum of the exercise price − the stock price or zero. C. zero. D. the exercise price.

Chapter 23 Test bank - Static Key 1.

The seller of a put option is betting that the market value of the stock will decrease. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuation fundamentals

The VIX is an estimate of expected future market volatility. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Capital market performance

A call option is worthless if the underlying stock is worthless. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuation fundamentals

The lower limit on a call option's value is equal to the greater of zero or the exercise price minus the stock price. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuation fundamentals

A strategy of buying the stock and selling the put is called a protective put. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy

Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option types and features

The value of a call option increases as the exercise price decreases. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

The Financial Accounting Standards Board (FASB) requires that companies recognize the fact that employee stock options are valuable and therefore are an expense just like salaries and wages. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Generally Accepted Accounting Principles (GAAP)

The Financial Accounting Standards Board (FASB) stipulates that companies must use an option valuation model to estimate the fair value of any option grants and then deduct this value when calculating profits. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Generally Accepted Accounting Principles (GAAP)

The value of both call and put options increases as the variability of the stock price decreases. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

10.

Callable bonds allow the investor to redeem the bond at face value or let the bond remain outstanding until maturity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Option combinations

11.

Warrants do not expire. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Warrants

12.

Convertible bonds give the investor the option to acquire the firm's stock in exchange for the value of the underlying bond. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

13.

Callable bonds give the call option to the issuing firm and hence reduce the value of the bond. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Option combinations

14.

The longer the time until expiration of a call option, the lower the value of the option. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

15.

Only at the expiration date can an investor expect to find the value of call options above their lower bound. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

16.

Stock price volatility is beneficial to option holders. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

17.

Unlike call options, the option to abandon a real asset can never be more valuable as time to expiration increases. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-03 Recognize options in capital investment proposals. Topic: Capital budgeting options

18.

A callable bond gives the issuer a potentially valuable option in the case of changing interest rates. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option combinations

19.

At expiration a call option will have no value if the stock price is less than exercise price. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

20.

At expiration a put option will have no value if the stock price is less than the exercise price. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

21.

A protective put is a way to eliminate the downside risk of holding stock. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option combinations

22.

The value of a call option increases as the exercise price increases. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

23.

When the stock price is very high compared with the exercise price, the value of the call option approximates the difference between the stock price and the present value of the exercise price. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuation fundamentals

24.

Warrants are long-term call options on a company's stock issued by an organized stock exchange. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Warrants

25.

A warrant is a long-term call option that is always "in the money" at the time of issuance. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Warrants

26.

A callable bond will have a lower value than a straight bond with the same coupon rate and maturity. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Option combinations

27.

The floor of a convertible bond is the value of the underlying bond. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

28.

The value of a convertible bond is always less than the value of a straight bond with similar coupon and maturity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

29.

The writer of a call option hopes that the stock price will: A. decrease. B. increase. C. split. D. produce quarterly cash dividends. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuation fundamentals

30.

Adding warrants as a "sweetener" to bonds will: A. reduce the value of the bond. B. increase the coupon rate of the bond. C. increase the value of the package. D. make the bond riskier. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Warrants

31.

If you own a call and a put on a stock with the same exercise price and exercise date, your payoffs: A. will be positive only if the stock price rises. B. will be positive only if the stock price declines. C. will always be positive and will increase with the size of the stock price change. D. will always be positive but will be larger if the stock price is relatively stable. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

32.

Which one of the following is true for the owner of a call option? A. The loss potential is unlimited. B. The profit potential is unlimited. C. The option price exceeds the exercise price. D. There is no expiration date, unless the option is a European call. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

33.

An increase in which one of the following will reduce the value of a call option? A. Interest rate B. Time to expiration C. Volatility of stock price D. Exercise price AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

34.

What is the difference between an American call option and a European call option? A. The European call has a final exercise date. B. The American call trades only on domestic stocks. C. The European call can be exercised only on one day. D. The American call generates profits regardless of which direction the stock moves. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

35.

What is the option buyer's total profit or loss per share if a call option is purchased for $5, has a $50 exercise price, and the stock is valued at $53 at expiration? A. −$5 B. −$2 C. $3 D. $8 Profit = $53 − 5 − 50 = −$2

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

36.

The maximum possible payoff to the owner of a put options is: A. the stock price. B. the exercise price minus the stock price. C. the option’s exercise price. D. there is no maximum. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

37.

Which one of the following option traders receives the price of the option? A. Option sellers B. Option buyers C. Both option sellers and buyers D. Neither buyers nor sellers receive the price AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option types and features

38.

Which one of the following is true for an investor who purchased a share of stock for $45 and purchased a put option on the stock with an exercise price of $45? A. The investor profits when the stock decreases in value. B. The minimum payoff on the position is $45. C. The investor is protected against upside potential. D. Increases in the value of the stock will go to the seller of the put. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option combinations

39.

An investor purchased a share of stock for $42 and at the same time paid $2 to purchase a put option on the stock with an exercise price of $40. What is her profit if the stock is worth $30 at expiration? A. $6 B. −$6 C. −$4 D. $4 Profit = $40 − 42 − 2 = −$4

40.

Which combination of positions will protect the owner from downside risk? A. Buy the stock and buy a call option B. Sell the stock and buy a call option C. Buy the stock and buy a put option D. Buy the stock and sell a put option AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option combinations

41.

If you feel strongly that a stock price will move a lot, but are unsure of the direction, you could: A. buy both a put and a call. B. sell both a put and a call. C. buy a put and sell a call. D. buy two puts. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option combinations

42.

A stock is currently selling for $70 per share. What is the lower limit on the value of a call option with an exercise of $90? A. −$20 B. $0 C. $10 D. $20 Lower limit on call = max[0,(stock price − exercise price)] = max[0,($70 − 90)] = $0

43.

Why does the value of a call option increase as the interest rate increases? A. The stock seller must pay the call owner more interest. B. The present value of the exercise price is reduced. C. As interest rates increase, stock prices increase. D. Interest rate increases reduce the option value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

44.

Which of the following statements is true of the holder of a call option? A. Option holders pay no income taxes. B. Holders of a call option have restricted profits. C. Option holders do not receive dividends D. Investors in call options do not have to exercise them and therefore cannot sustain losses. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option types and features

45.

How much must the stock be worth at expiration in order for the buyer of a call option to break even if the exercise price is $50 and the cost of the call was $4? A. $46 B. $50 C. $52 D. $54 Break even = $50 + 4 = $54

46.

What is the most an investor can lose if sells a call on the firm's stock with an exercise price of $100? A. $100 B. $0 C. $50 D. Unlimited losses AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

47.

Which one of the following call options would command the higher price, other things equal? (All months are within the same calendar year.) A. October expiration, $45 exercise price B. December expiration, $40 exercise price C. March expiration, $45 exercise price D. June expiration, $40 exercise price AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

48.

Put-call parity states that: A. Price of stock + price of call = price of put + PV(exercise price) B. Price of stock + PV(exercise price) = price of call + price of put C. Price of stock + price of put = price of call + PV(exercise price) D. Price of stock = price of put + price of call − exercise price AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuation fundamentals

49.

Executive stock options are issued with the hope that the recipients will: A. sell the shares they currently own thereby diversifying the firm's ownership. B. work to increase the value of the firm's stock. C. never exercise them. D. sell their shares at the option's exercise price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Employee stock options

50.

The major difference between options on real assets and options on financial assets is that options on: A. financial assets are costly. B. financial assets have a higher probability of positive payoff. C. real assets are implicit, rather than explicit. D. real assets are not influenced by price volatility. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-03 Recognize options in capital investment proposals. Topic: Capital budgeting options

51.

The option to abandon a project investing in real assets can be considered to have an exercise price equal to the: A. historical cost of the asset. B. resale value of the asset at abandonment. C. foregone revenues anticipated from the project. D. foregone interest on the bonds used to finance the real assets. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-03 Recognize options in capital investment proposals. Topic: Capital budgeting options

52.

Investors who hold warrants essentially have a: A. put option on the firm's bonds. B. put option on the firm's equity. C. call option on the firm's bonds. D. call option on the firm's equity. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Warrants

53.

The conversion ratio for a convertible bond equals the: A. number of interest payments that must be received prior to conversion. B. number of bonds necessary to convert into one share of stock. C. number of shares of stock that can be exchanged for one bond. D. floor value beneath which the bond price cannot fall. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

54.

If a $1,000 convertible bond with a market value of $950 has a conversion ratio of 25 when the firm's stock is selling for $36 per share, then: A. the bond will be converted immediately. B. the bond is violating its price floor. C. conversion now would give the investor a profit of $900. D. the conversion value of the bond is $900. Conversion value = 25 × $36 = $900

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

55.

If a $1,000 convertible bond has a conversion ratio of 50 and the firm's equity is currently selling for $22 per share, then the: A. bond should trade for at least $900. B. bond should trade for at least $1,000. C. bond should trade for at least $1,100. D. firm will have already converted the bond. Conversion value = 50 × $22 = $1,100

56.

Which one of the following conditions will typically be present when a firm calls a bond prior to maturity? A. The firm is in poor financial health. B. Interest rates have risen substantially since the bond was issued. C. Interest rates have fallen substantially since the bond was issued. D. The call option is about to expire. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Bond refunding

57.

The value of a callable bond equals the value of a straight bond: A. plus the value of the bondholder's call option. B. minus the value of the bondholder's call option. C. plus the value of the issuer's call option. D. minus the value of the issuer's call option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Bond valuation

58.

A 10% convertible bond has a conversion ratio of 25. The firm’s common stock is currently selling at $35. If the bond is about to mature, what is its value? A. $875 B. $1,000 C. $1,125 D. $1,875 Conversion value = 25 × $35 = $875. Investors will prefer to let the bond mature and receive $1,000.

59.

Which one of the following statements is correct? A. A convertible bond will be worth less than a similar non-convertible bond. B. A callable bond will be worth less than a similar non-callable bond. C. A callable bond will be worth more than a similar convertible bond. D. Warrants are always worth more than convertible bonds.

AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

60.

A put and a call both have the same maturity and both have an exercise price which is equal to the current stock price. The interest rate is 5%. Which option should sell for a higher price? A. the put. B. both should sell for the same price. C. the call. D. can’t say without knowing the variability of the stock. From put-call parity Price of call = price of stock + price of put − PV(exercise price). If the exercise price = the stock price, price of the call is greater than that of the put.

AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 3 Hard Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Options

61.

Which one of the following is correct for the owner of a June call on XYZ Corp. with an exercise price of $60? XYZ Corp. currently trades at $55 and the option at $3. A. XYZ stock will go to $63 per share within the option period. B. The option should be exercised now. C. The option owner's current profit is $3 per share. D. The option may expire without value. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

62.

It is May and you own a June call on ABC Corp. with an exercise price of $50. The option trades at $40 and ABC is trading at $86. What should you do? A. Exercise the option now and take the profits. B. Buy the stock of ABC Corp because option traders seem to be optimistic about its prospects. C. Sell your ABC stock before its price declines. D. Sit and wait until the June expiration. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option types and features

63.

At what point does the value of a call option lie furthest above its lower bound (that is, the maximum of zero or the stock price − exercise price)? A. When the stock price is zero. B. When the stock price is very high relative to the exercise price. C. When the stock price equals the exercise price. D. It depends on the maturity of the option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

64.

You own a September put on CBA Corp. with an exercise price of $80. CBA stock currently trades at $80 and the put at $5. Which of the following is definitely true? A. The option will continue to gain value until its September expiration. B. The owner should exercise now in order to avoid further losses. C. Decreases in the CBA stock price will be translated directly into additional option value. D. $20 is the maximum value for this option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

65.

The buyer of a put option has a(n) _____ to sell the underlying asset and the option seller has a(n) ____ to buy the underlying asset. A. obligation; obligation B. obligation; right C. right; right D. right; obligation AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option types and features

66.

Joe sold a put option on ZZZ Corp. with an exercise price of $40. The option is about to expire and ZZZ stock is currently trading at $28 per share. What is the value of Joe’s position? A. $12 B. −$12 C. $8 D. $16 Value of Joe’s Position = $40 − $28 = −$12

67.

Maria sold a call option on XXX Corp. with an exercise price of $50. The option is about to expire and stock XXX is currently trading at $40. What is the value of Maria's position? A. −$10 B. $0 C. $7 D. $10 AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

68.

The payoffs from investing in an option contract are designed so that: A. both the buyer and the seller of the contract will profit. B. the seller's (buyer's) gain is the buyer's (seller's) loss. C. roughly 20% of sellers and 50% of buyers profit. D. there are no profits but there are also no losses. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

69.

Under what circumstance will the buyer of a put option need to fulfill her obligation? A. When the stock price has declined below the exercise price. B. When the stock price has increased above the exercise price. C. The put buyer has an equal obligation regardless of the relationship between stock and exercise prices. D. The put buyer has no obligation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option types and features

70.

Which one of the following statements is correct for an investor who has purchased portfolio insurance by owning a stock and buying a put option on that stock? A. The investor profits when the stock price declines. B. Maximum profitability occurs when the stock price equals the exercise price. C. The value of the position can decline no further than the option’s exercise price. D. The option will certainly be exercised. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option combinations

71.

A call option will have the highest value when the stock price is: A. far above the exercise price. B. closest to the exercise price. C. approaching zero. D. less than the exercise price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values.

Topic: Option valuation fundamentals

72.

When does a change in the value of a call option come closest to matching the change in the price of the stock? A. When the stock is priced far above the exercise price. B. When the stock is priced far below the exercise price. C. When the stock is priced near zero. D. Changes in call value always come close to matching changes in stock price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

73.

At what point is the dollar payoff from owning a call option on a stock greater than the payoff from owning the stock itself? A. When stock price exceeds exercise price at expiration. B. When exercise price exceeds stock price at expiration. C. When stock price equals exercise price at expiration. D. Call payoff never exceeds stock payoff. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

74.

What is the lower bound on the value of a put option? A. Maximum of zero or exercise price − stock price B. Maximum of zero or stock price − exercise price C. Stock price − exercise price D. Exercise price − stock price AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

75.

The value of a call option increases as the time to expiration increases because: A. the exercise price continually decreases. B. the opportunity increases for the stock price to exceed the exercise price. C. the dividends accumulate while waiting to be paid. D. the option can be repeatedly exercised. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic

Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

76.

Stocks that have more volatile price changes have more valuable call options because call holders: A. capture upside potential without additional downside risk. B. realize that volatility decreases the present value of the exercise price. C. have too little variability in the exercise price. D. have transferred all risk to put holders. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

77.

Of the following four put options that can be purchased on a stock, which would you expect to have the highest price? (All option months are in the same calendar year.) A. September put; $65 exercise price B. September put; $75 exercise price C. December put; $65 exercise price D. December put; $75 exercise price AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

78.

A share of stock is currently priced at $20 and will change with equal likelihood to either $40 or $10. A call option with a $20 exercise price is available on the stock. The interest rate is zero. Which of the following positions will provide (approximately) the same payoffs as the option? A. Buy 0.667 shares and lend $6.67 B. Buy 0.667 shares and borrow $6.67 C. Buy 0.5 shares D. Sell 0.667 shares and borrow $0.667 If share price falls to $10, option is worth $0 and position in share is worth $6.67 − $6.67 = $0 If share price rises to $40, option is worth $20 and position in share is worth 0.667 × $40 − $6.67 = $20

79.

Which of the following is not a real option? A. If tanker rates fall, the company can lay up its fleet B. The extra warehouse space allows the company to expand C. The company replaces an ageing machine tool D. If oil prices rise the company can switch to using gas AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuations and payoffs

80.

Real options are: A. options on real assets such as an option to abandon. B. call and put options traded on organized exchanges. C. call options such as warrants and convertible bonds. D. put options such as those held by shareholders of a firm with financial leverage. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-03 Recognize options in capital investment proposals. Topic: Capital budgeting options

81.

Corporations that attach warrants to their bonds are hoping to: A. repurchase shares of outstanding stock. B. convert the bonds into stock at a later date. C. increase the value of the bonds. D. increase the price of their shares. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Warrants

82.

If a convertible bond can be thought of as a straight bond with a call option, then the call is owned by the _____, and the exercise price is the _____. A. debt issuer; stock price B. debt issuer; straight bond value C. bond investor; stock price D. bond investor; straight bond value AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities.

Topic: Convertible securities

83.

Why should a convertible bond always be valued at more than its bond value or its conversion value up until maturity? A. The bond holder is receiving higher interest rates. B. The holder can decide later whether to own the bond or the stock. C. The conversion ratio may be decreased. D. The bond does not have to be given up to exercise the option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

84.

A 10-year convertible bond has a face value of $1,000, a 9% coupon, and a conversion ratio of 30. The stock is currently priced at $35. If a comparable straight bond would have a yield of 9%, what is the minimum value of the call option provided by the convertible? A. $0 B. $5 C. $50 D. $65 Bond value = $1,000 because coupon rate = market rate Conversion value = 30 × $35 = $1,050 Value of call = $1,050 − 1,000 = $50

85.

Which one of the following is correct? A. There is an upper bound on a callable bond's price. B. Callable bond prices are higher than those of comparable straight bonds. C. The attraction of callable bonds to the issuer increases as interest rates increase. D. The investor in a callable bond owns the call option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Option combinations

86.

The value of a call option at expiration will be equal to the maximum of zero or the: A. stock price. B. exercise price. C. stock price minus the exercise price. D. exercise price minus the stock price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

87.

Kingston Lisle shares are currently selling at $75. The value of a call option on the company’s shares with an exercise price of $60 and several months to expiration is: A. less than $15. B. greater than $15. C. equal to $15. D. zero. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

88.

You purchased a call option with an exercise price of $50. If you exercise the option when the stock price is $60, your proceeds will be: A. $10. B. $0. C. $4. D. $16. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

89.

Three months ago you bought a put option with an exercise price of $100. What is the value of this option at expiration if the stock price is $110? A. $10 B. −$110 C. $0 D. −$10 AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze

Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

90.

A firm is planning to issue a callable bond with a coupon rate of 8% and 10 years to maturity. A straight bond with a similar coupon is priced at $1,000. If the value of the issuer's call option is $60, what is the value of the callable bond? A. $940 B. $970 C. $1,000 D. $1,060 AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-04 Identify options that are provided in financial securities. Topic: Convertible securities

91.

A stock is selling for $85 at the expiration of an option contract. Which of the following options on the stock will most likely be exercised? A. Call option with exercise price of $65 B. Put option with exercise price of $65 C. Call option with exercise price of $85 D. Put option with exercise price of $85 AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

92.

Which one of the following changes will reduce the value of a call option? A. An increase in the stock price B. An increase in the exercise price C. An increase in the volatility of the stock price D. An increase in interest rates AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

93.

An investor who sells a put option profits if: A. stock prices go up. B. stock prices go down. C. the put is exercised. D. interest rates go up. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

94.

A call option has an exercise price of $60. When the option expires, the price of the stock is exactly $60. What is the value of your call option? A. $1 B. −$1 C. Zero D. $60 AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-02 Understand the determinants of option values. Topic: Option valuation fundamentals

95.

The value of a put at expiration is defined as the: A. minimum of zero or the stock price minus the exercise price. B. minimum of zero or the exercise price minus the stock price. C. maximum of zero or the stock price minus the exercise price. D. maximum of zero or the exercise price minus the stock price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuation fundamentals

96.

You purchased a stock for $36 a share, a call option with an exercise price of $35, and a put option with an exercise price of $34. What will be the value of your position when the options expire if the stock price is $37? A. $39 B. $37 C. $40 D. $2 Stock value = $37; call value = $2; put value = $0

AACSB: Analytical Thinking

Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option combinations

97.

You purchased a stock for $43 a share, sold a call option with an exercise price of $40, and bought a put option with an exercise price of $45. What will be the value of your position when the options expire if the stock price is $48 a share? A. $48 B. $46 C. $56 D. $40 Stock value = $48: call position = −$8; put position = $0

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 3 Hard Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option combinations

98.

You purchased a stock and a put option on the stock with an exercise prices of $40 a share. What will be the value of your position when the option expires if the stock price is $28 a share? A. $40 B. $28 C. $12 D. $32 Stock value = $28: put position = $12

99.

If you sell a put option, your maximum payoff is equal to: A. The maximum of zero or the stock price − the exercise price. B. The maximum of the exercise price − the stock price or zero. C. zero. D. the exercise price. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options. Topic: Option valuations and payoffs

Chapter 23 Test bank - Static Summary Category AACSB: Analytical Thinking

# of Questions 22

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Difficulty: 3 Hard

Gradable: automatic

Learning Objective: 23-01 Calculate the payoff to buyers and sellers of call and put options.

Learning Objective: 23-02 Understand the determinants of option values.

Learning Objective: 23-03 Recognize options in capital investment proposals.

Learning Objective: 23-04 Identify options that are provided in financial securities.

Topic: Bond refunding

Topic: Bond valuation

Topic: Capital budgeting options

Topic: Capital market performance

Topic: Convertible securities

Topic: Employee stock options

Topic: Generally Accepted Accounting Principles (GAAP)

Topic: Option combinations

Topic: Option types and features

Topic: Option valuation fundamentals

Topic: Option valuations and payoffs

Topic: Options

Topic: Warrants

Chapter 24 Test bank - Static Student: ___________________________________________________________________________

The majority of large companies use derivatives in some way to manage their risk. True

Insurance is often an effective way to reduce risk when the insurance company can spread its risk over many different policies. True

False

Firms use options to speculate not to reduce risk. True

False

Properly managed, hedging can be a very profitable activity. True

False

Futures contracts are custom-tailored forward contracts. True

False

Unless the corporation has reason to believe that the odds are stacked in its favor, it should use derivatives for speculation, not for hedging. True

False

A company that hedges simply passes the risk on to someone else. True

False

A swap is an arrangement by two counterparties to exchange one stream of cash flows for another. True

False

Mexico purchased call options to lock in the price of its oil and create a base floor for its revenue stream. True

False

10. A firm might enter a swap contract whereby it agrees to make a series of regular payments in one currency in return for receiving a series of payments in another currency. True

False

11. Swap contracts can be based on either interest rates or currencies. True

False

12. A commodity producer can place a floor on its revenues by selling put options on the commodity. True

False

13. A producer that uses options to reduce downside risk is buying a "protective put." True

False

14. A commodity producer that uses put options to reduce the risk of a fall in commodity prices is effectively buying insurance. True

False

15. An oil producer would sell, rather than buy, crude oil futures to protect against falling oil prices. True

False

16. Futures contracts are standardized to expire on the same day each year. True

False

17. Buyers of financial futures place an order to buy a financial asset at a future date. True

False

18. Speculators are a necessary component of well-functioning futures markets. True

False

19. Forward contracts are marked to market. True

False

20. In a typical interest rate swap the two parties will exchange a series of fixed payments for a series of payments that are linked to the level of interest rates. True

False

21. Hedging may increase a company’s debt capacity. True

False

22. By using options a firm can (at a cost) protect against increases in raw material prices, while continuing to benefit from price decreases. True

False

23. Unlike options, the purchase of a futures contract is a binding obligation to purchase at a fixed price at contract maturity. True

False

24. The profit to the buyer of a futures contract is equal to the initial futures price minus the ultimate market price. True

False

25. Investors can hedge against a change in house prices by purchasing real estate futures contracts. True

False

26. Exchange traded futures contracts allow the seller to choose the place of delivery for the commodity. True

False

27. Both the seller and the buyer in a futures contract are required to put up margin. True

False

28. A farmer can avoid delivery on a futures contract by buying an offsetting futures contract. True

False

29. Companies should always leave investors to hedge for themselves. True

False

30. The derivatives market is characterized by: A. shrinking activity. B. the introduction of new contracts. C. low turnover. D. regular IPOs. 31. A bond investor who is worried about future fluctuations in interest rates could: A. enter into a swap to pay both a fixed and a floating rate. B. enter into a swap to pay a fixed rate and receive a floating rate. C. enter into a swap to pay a floating rate and pay a fixed rate. D. enter into a swap to receive both a fixed and a floating rate. 32. Which one of the following is not generally considered a benefit of hedging? A. Hedging reduces business risk. B. Hedging allows prices to be locked in ahead of time. C. Hedging can be very profitable. D. Hedging can stabilize profits. 33. Which one of the following futures contracts is written on an asset that cannot be delivered? A. U.S. Treasury bills B. Wheat C. Standard and Poor's index D. British pounds

34. How might a firm such as General Mills protect itself against fluctuations in raw material prices for breakfast cereals? A. Buy commodity futures B. Sell commodity futures C. Buy put options on commodities D. Sell put options on commodities 35. The buyer of a credit default swap: A. gains protection against a fall in house prices. B. gains protection against default by a pension scheme. C. insures the seller against a fall in house prices. D. gains insurance against default on a bond. 36. What form of insurance would you suggest for a producer that wishes to be protected from future price decreases but wants to benefit from any future price increases? A. Buy a call option on the asset B. Sell a call option on the asset C. Buy a put option on the asset D. Sell a put option on the asset 37. Which one of the following is not correct concerning futures contracts? A. Futures contracts entail an obligation rather than an option. B. The contract price is set at the beginning of the contract. C. The contracts are exchange-traded. D. Gains and losses are not settled until the contract expires. 38. Selling a futures contract may be appropriate for someone who wishes to: A. lock in a future sales price. B. lock in a future purchase price. C. speculate that future spot prices are going up. D. have a ready market in which to sell a product. 39. A speculator who buys a futures contract is betting that prices will _____ by the expiration of the contract. A. decrease B. increase C. remain constant D. guarantee high profits 40. A speculator who sells a futures contract is betting that prices will _____ by the expiration of the contract. A. decrease B. increase C. remain constant D. Be unusually volatile

41. What happens to the price of a futures contract as expiration draws closer? A. The futures price exceeds the spot price of the asset. B. The futures price is exceeded by the spot price of the asset. C. The futures price approaches the spot price of the asset. D. There is no relationship between the futures price and spot price as the contract approaches expiration. 42. When a commodity futures reaches its expiration, the seller usually: A. delivers the commodity to the futures buyer. B. delivers the commodity to the futures exchange. C. takes an offsetting futures position and settles in cash. D. adds the profit or loss to his margin account and continues to trade. 43. A commodity producer who is worried about future prices can best hedge by: A. buying a futures contract. B. selling a futures contract. C. buying a call option. D. selling a call option. 44. A farmer sells corn futures for March delivery at $7.50 per bushel. In March the spot price of corn is $7.20 per bushel. Which of the following is correct? A. The futures buyer is required to deliver corn to the farmer at $7.20. B. The farmer has locked in an effective price of $7.50 per bushel. C. The farmer would have been better off without the futures contract. D. The farmer will receive $7.35 per bushel which is the average of the spot and futures prices. 45. A milling company buys a futures contract that requires it to take delivery of 5,000 bushels of wheat at a price of $6.80 per bushel. At expiration the spot price of wheat is $6.68 per bushel. The miller: A. has saved $0.12 per bushel through hedging. B. has locked in an effective price of $6.80 per bushel. C. can choose not to take delivery since the price declined. D. has locked in an effective price of $6.68 per bushel. 46. A milling company buys a futures contract that requires it to take delivery of 5,000 bushels of wheat at a price of $6.75 per bushel. Next day the price of the future is $6.80. The miller: A. must pay an extra $0.05 a bushel into its margin account. B. can withdraw $0.05 from its margin account. C. does not need to do anything until the contract matures. D. can’t say without knowing what happened to the spot price.

47. Yesterday you sold six-month futures on the S&P index at a price of 2,100. Today the index closed at 2,050 and the future at 2,140. You get a call from your broker. Is he: A. asking you to pay $40 times the contract size into your margin account? B. asking you to pay $50 times the contract size into your margin account? C. telling you that you can withdraw $40 times the contract size from your margin account? D. telling you that you can withdraw $50 times the contract size from your margin account? 48. Which one of the following would not be regulated in a standardized futures contract? A. Quantity of asset to be traded B. Quality of asset to be traded C. The spot price D. Date of settlement 49. The purpose of a margin account for a futures contract is to: A. guarantee a minimum margin of profit for the contract holder. B. allow futures traders to have more than one contract simultaneously. C. provide a cushion for the exchange against defaults on the contract. D. hold interest payments until expiration. 50. The process of marking a futures contract to market means that: A. the profitability of the contract is locked in from the onset of the contract. B. the amount of commodity to be delivered changes as prices change. C. contracts are closed out as soon as they become unprofitable. D. profits or losses are settled daily. 51. A futures contract calls for delivery of 60,000 pounds of soybean oil. What happens to the seller of a soybean oil futures contract at 41 cents per pound if the futures price closes the next day at 42 cents per pound? A. The contract is marked to market with a $600 loss. B. The contract is marked to market with a $600 gain. C. Futures contracts are voided if the price increases prior to expiration. D. Nothing happens until the expiration of the contract. 52. A futures contract seller is obligated to deliver 5,000 bushels of soybeans for $12.00 per bushel at expiration. If soybean futures close at $12.10 the next day, the seller: A. has a profit of $500 thus far on the contract. B. has a loss of $500 thus far on the contract. C. has no profit or loss, but is still obligated to deliver 5,000 bushels at $12.00. D. will receive a check for $500 from the buyer of the contract. 53. What has happened to cause a $250 loss to be marked to the margin account of a futures contract buyer? A. The commodity futures price decreased on that day. B. The commodity futures price increased on that day. C. The commodity spot price decreased on that day. D. The commodity spot price increased on that day.

54. The effect of marking a futures contract to market is similar to: A. doubling the total payments by the contract buyer. B. doubling the total payments by the contract seller. C. closing the current position and opening a new position daily. D. imposing a daily fee on both buyers and sellers. 55. The primary purpose of financial futures is to: A. benefit from increases in interest rates. B. protect against swings in interest rates or prices of financial assets. C. translate one currency into another. D. guarantee the repayment of loan principal. 56. The basic difference between speculators and hedgers in futures contracts is that speculators: A. will profit regardless of the direction of price change. B. do not have an offsetting position in the underlying commodity. C. are concerned only with long-term price movements. D. take a position in more than one commodity at a time. 57. If there is an excess of market participants who want to buy the futures as a hedge, then: A. speculators will come into the market to sell the futures. B. speculators will see a potential profit from also buying the futures. C. speculators will steer clear of the futures market. D. the market may have to close down until there is a balance of supply and demand. 58. Which one of the following is not correct concerning forward contracts? Forward contracts: A. are not standardized. B. do not set the price until the end of the contract. C. are not traded on organized exchanges. D. are not marked to market daily. 59. You enter into a forward contract to take delivery of 1 million euros 3 months from now. What happens to the price you will pay at expiration if the euro depreciates during the contract period? A. Your price will increase. B. Your price will decrease. C. Your price was fixed at the onset of the contract. D. Your price was fixed but you will receive correspondingly more euros due to the depreciation. 60. Which one of the following is a reason for firms to engage in currency swaps? A. They will be required to repay only the interest. B. They can obtain more favorable terms by borrowing in a different currency. C. The debt will not show on their balance sheets. D. You can borrow in the currency with the lowest interest rate without taking on any currency risk.

61. When two borrowers engage in a currency swap, they agree to: A. a one-time currency exchange equal to the principal amount borrowed. B. make payments to each other in a different currency. C. pay to each other any depreciation or appreciation of the currency. D. exchange fixed-rate interest payments for variable-rate interest payments. 62. In an interest rate swap, borrowers typically exchange fixed-rate payments in one currency for: A. fixed-rate payments in another currency. B. variable-rate payments in another currency. C. fixed-rate payments in the same currency. D. variable-rate payments in the same currency. 63. ABC Corp. borrows $5 million at 10% from a bank and swaps this loan for a 12% yen loan. The spot exchange rate is JPY105 = USD1. How much does ABC pay annually to the bank? A. ¥1.26 million B. ¥5.71 million C. ¥52.50 million D. ¥63.00 million 64. Which of the following statements is correct? A. Futures contracts and options contracts are economically similar, but vary in how they are traded. B. Forward contracts and futures contracts are economically similar, but vary in how they are traded. C. Forward contracts and options contracts are economically similar, but vary in how they are traded. D. Forward contracts, futures contracts, and options contracts are all economically similar, but vary in how they are traded. 65. The term derivatives refers to: A. forwards and futures. B. swaps and options. C. forwards, futures, swaps, and options. D. forwards, futures, and swaps. 66. A derivatives contract: A. increases the risk of both the hedger and speculator. B. increases the risk of the hedger and decreases the risk of the speculator. C. reduces the risk of the hedger and increases the risk of the speculator. D. reduces risk in both cases.

67. Hershey's Chocolate is concerned about cocoa prices, which are currently $3,000 a ton. Analysts project that the cost of cocoa purchases could vary from $2,900 to $3,100 a ton. A September call option can be purchased with a $2,950 exercise price for $145. What is Hershey's worst-case scenario if it purchases these options? A. Cocoa prices will rise to $3,100 and Hershey is protected only to a price of $2,950. B. Cocoa prices will not change from their current level and Hershey will have wasted the cost of the option. C. Cocoa prices will not rise above Hershey's break-even price of $3,095, which equals the sum of the exercise price plus the cost of the option. D. Cocoa prices will fall below $2,950 and Hershey will lose the $145 cost of the option. 68. If you buy a forward contract, you agree to buy the product: A. at a later date at a price to be set in the future. B. today at its current price. C. at a later date at a price set today. D. if and only if its price rises above its exercise price. 69. If you sell a forward contract, you agree to: A. deliver a product at a later date for a price set today. B. receive a product at a later date at the price on that later date. C. receive a product at a later date for a price set today. D. deliver a product at a later date for a price set on that later date. 70. One distinguishing difference between the buyer of a futures contract and the buyer of an option contract is that the futures buyer: A. pays a much higher up-front price than option buyers. B. has an obligation to purchase, not a choice. C. can lose no more than the initial outlay. D. has increased rather than reduced risk. 71. In general, when deciding whether one needs to buy or sell futures contracts in order to hedge, the rule could be: A. buy futures if you have the underlying asset and sell futures if you need the underlying asset. B. sell futures if you have the underlying asset and buy futures if you need the underlying asset. C. buy futures if you want to speculate, sell futures if you want to hedge. D. buy futures if you are willing to have unlimited risk, sell futures if you want capped risk. 72. As time draws closer to contract expiration, futures prices can be expected to: A. increase as the demand for delivery intensifies. B. decrease as speculators resolve the uncertainty of prices. C. move similarly to broad-based market indices, such as the S&P 500. D. converge upon the spot price. 73. Why are most futures contracts not settled through delivery of the product? A. Most contracts are settled through the margin account. B. Most contracts expire with neither party having an obligation to the other party. C. Most participants cancel their futures contracts through purchase of an option contract. D. It is easier and cheaper to settle in cash or by an offsetting futures transaction.

74. The price for immediate delivery of a product is called the: A. spot price. B. exercise price. C. forward price. D. the impact price. 75. If you enter into an interest rate swap, the company taking the opposite side is called: A. The swap payer. B. The swap counterparty. C. The swap maker. D. The off-taker. 76. A gasoline distributor buys a gasoline futures contract to receive 42,000 gallons of gasoline at $2.94 per gallon. How is the account marked to market if gasoline futures close the next day at $2.97? A. A loss of $1,260 is posted to the account. B. A gain of $1,260 is posted to the account. C. A loss of $12,600 is posted to the account. D. A gain of $12,600 is posted to the account. 77. The seller of a pork bellies futures contract at $1.41 per pound noted that the closing price of pork bellies was $1.44 today. What will happen to this contract, which requires delivery of 40,000 pounds of pork bellies at expiration? A. A loss of $400 is posted to the account. B. A gain of $400 is posted to the account. C. A loss of $1,200 is posted to the account. D. A gain of $1,200 is posted to the account. 78. The typical sequence of cash flows in a futures contract is: A. purchase price plus a margin account up-front, differences are settled at expiration. B. margin account up-front, differences are posted daily and settled in cash if margin drops too low. C. margin account up-front, all differences settled at expiration. D. all funds are paid at expiration of the contract. 79. The seller of a copper futures contract noticed that his account was marked with a $500 gain yesterday. If the standardized contract requires delivery of 25,000 pounds of copper, what happened that day to the price of copper? A. The price closed down $0.02 per pound. B. The price closed up $0.02 per pound. C. The price closed down $0.20 per pound. D. The price closed up $0.20 per pound. 80. Which of the following contracts is not a financial future? A. eurodollar deposit futures B. yen futures C. orange juice futures D. Standard & Poor’s futures

81. Which one of the following is not true of the financial futures markets? A. Financial futures trade on the Chicago Mercantile Exchange. B. When many financial future mature, the seller cannot deliver the asset to the buyer. C. A major use of financial futures is protection from interest rate risk. D. Trading in financial futures is significantly less than trading in financial futures. 82. A clothes producer hedges its future cotton purchases by buying cotton futures. The futures contract provides the producer with 50,000 pounds of cotton at a price of $0.80 per pound. By contract expiration the producer finds that cotton prices have declined to $0.73 per pound. As a result of the futures contracts, the producer will: A. lose $3,500 per contract in the futures market which offsets gains in the cash market. B. gain $3,500 per contract in the futures market which offsets losses in the cash market. C. lose $3,500 per contract in the futures market and suffer an opportunity cost in the cash market. D. gain $3,500 per contract in the futures market and gain $0.07 per pound in the cash market. 83. Which one of the following futures contract holders is speculating? A. A wheat farmer who sells wheat futures B. A cattle rancher who buys live cattle futures C. A candy maker who buys sugar futures D. An oil producer who sells crude oil futures 84. The activities of speculators are necessary in the futures markets in order to: A. prevent hedgers from trading options. B. provide a continual stream of profit to hedgers. C. help ensure futures prices are fair value. D. understand the direction of future price changes. 85. Those who invest in derivative instruments that increase rather than reduce risk are known as: A. option traders. B. futures traders. C. hedgers. D. speculators. 86. Which one of the following characteristics is similar in both futures and forward contracts? A. Future transactions are conducted at a price agreed upon earlier. B. Contracts are sold through organized exchanges. C. Contract terms are standardized by type of commodity. D. Price changes are settled daily in a process known as mark-to-market. 87. A contract to buy Japanese yen three months forward at a price of ¥105/$ will: A. insulate the buyer from changes in interest rates. B. protect the buyer from changes in exchange rates. C. lock in a profit based on current exchange rates. D. require delivery of the yen at the Nasdaq Exchange.

88. Zeta Corp wishes to obtain a loan denominated in Swiss francs but the U.S. market offers better credit terms. What should Zeta do? A. Borrow francs in Switzerland, exchange for dollars, and arrange a currency swap. B. Borrow francs in Switzerland, exchange for dollars, and arrange an interest rate swap. C. Borrow dollars in the United States, exchange for francs, and arrange an interest rate swap. D. Borrow dollars in the United States, exchange for francs, and arrange a currency swap. 89. Currency swaps are used to: A. lock in an exchange rate for future delivery of a foreign currency. B. effectively transform loans originated in one currency to a different currency. C. transform fixed-rate loans into variable-rate loans. D. exchange foreign currencies in amounts not possible in the foreign exchange market. 90. On $10 million of loans, Firm A is paying a fixed $700,000 in interest payments while Firm B is paying LIBOR plus 50 basis points. The current LIBOR rate is 6.25 percent. Firms A and B have agreed to swap interest payments. How much will be paid to which firm this year? A. A pays $750,000 to Firm B. B. B pays $25,000 to Firm A. C. B pays $50,000 to Firm A. D. A pays $25,000 to Firm B. 91. Four investors buy sugar futures. Three are speculators and one is hedging. Which of the following is hedging? A. wheat farmer B. mutual fund C. soft drink producer D. none of the options 92. A firm can reduce the risk of upward movement in raw material prices by: A. buying a call option. B. selling a put option. C. buying a put option. D. selling a futures contract. 93. A farmer can hedge the risk of downward movement in the price of his product by: A. buying a call option. B. selling a put option. C. buying a put option. D. buying a futures contract. 94. A sensible corporate risk strategy needs answers to three of these questions. Which is the odd man out? A. What are the major risks that the company faces? B. Is the company being paid for taking these risks? C. Can we spot any mispriced derivative contracts? D. Can the company reduce the probability of a bad outcome?

95. A farmer hedged his risk by buying put options on wheat with an exercise price of $6.70 at a price of $0.14 per bushel. If the price of wheat at the expiration of the contract is $6.70, what is the net revenue from each bushel of wheat? A. $6.56 B. $6.63 C. $6.70 D. $6.84 96. Which of the following strategies does not reduce risk? A. building flexibility into the firm’s operations B. increasing the proportion of the firm’s costs that are fixed C. taking out an insurance policy D. hedging with derivative contracts 97. Which of these statements is not true? A. Transactions to reduce risk are unlikely to add value if investors can easily undertake similar transactions. B. Hedging may reduce the costs of financial distress. C. Transactions to reduce risk always add value. D. Hedging is a zero-sum game. 98. Which one of the following statements is correct? A. An option seller makes more profits than an option buyer. B. A futures seller makes more profits than a futures buyer. C. The profit realized by the buyer of futures will be equal to the loss incurred by the seller. D. Both the buyer and the seller of a futures contract can earn a profit. 99. The most active trading in forward contracts is in: A. U.S. Treasury bills. B. the Standard and Poor's index. C. wheat crops. D. foreign currencies. 100. At the expiration of a futures contract, the futures price will be: A. greater than the spot price. B. equal to the spot price. C. less than the spot price. D. greater than the forward price. 101. Which one of the following is the major difference between forward and futures contracts? A. Futures contracts are more expensive than forward contracts. B. Forward contracts are traded on the forward exchanges. C. Futures contracts are always delivered. D. Forward contracts are not marked to market.

Chapter 24 Test bank - Static Key 1.

The majority of large companies use derivatives in some way to manage their risk. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Risk management

Insurance is often an effective way to reduce risk when the insurance company can spread its risk over many different policies. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Risk management

A swap is an arrangement by two counterparties to exchange one stream of cash flows for another. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

A company that hedges simply passes the risk on to someone else. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

Unless the corporation has reason to believe that the odds are stacked in its favor, it should use derivatives for speculation, not for hedging. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging

Futures contracts are custom-tailored forward contracts. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

Properly managed, hedging can be a very profitable activity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

Firms use options to speculate not to reduce risk. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

Mexico purchased call options to lock in the price of its oil and create a base floor for its revenue stream. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

10.

A firm might enter a swap contract whereby it agrees to make a series of regular payments in one currency in return for receiving a series of payments in another currency. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

11.

Swap contracts can be based on either interest rates or currencies. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

12.

A commodity producer can place a floor on its revenues by selling put options on the commodity. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

13.

A producer that uses options to reduce downside risk is buying a "protective put." TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

14.

A commodity producer that uses put options to reduce the risk of a fall in commodity prices is effectively buying insurance. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

15.

An oil producer would sell, rather than buy, crude oil futures to protect against falling oil prices. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies.

Topic: Hedging with futures contracts

16.

Futures contracts are standardized to expire on the same day each year. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

17.

Buyers of financial futures place an order to buy a financial asset at a future date. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

18.

Speculators are a necessary component of well-functioning futures markets. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

19.

Forward contracts are marked to market. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

20.

In a typical interest rate swap the two parties will exchange a series of fixed payments for a series of payments that are linked to the level of interest rates. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

21.

Hedging may increase a company’s debt capacity. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

22.

By using options a firm can (at a cost) protect against increases in raw material prices, while continuing to benefit from price decreases. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

23.

Unlike options, the purchase of a futures contract is a binding obligation to purchase at a fixed price at contract maturity. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

24.

The profit to the buyer of a futures contract is equal to the initial futures price minus the ultimate market price. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

25.

Investors can hedge against a change in house prices by purchasing real estate futures contracts. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

26.

Exchange traded futures contracts allow the seller to choose the place of delivery for the commodity. FALSE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

27.

Both the seller and the buyer in a futures contract are required to put up margin. TRUE AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

28.

A farmer can avoid delivery on a futures contract by buying an offsetting futures contract. TRUE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

29.

Companies should always leave investors to hedge for themselves. FALSE AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

30.

The derivatives market is characterized by: A. shrinking activity. B. the introduction of new contracts. C. low turnover. D. regular IPOs. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies.

Topic: Futures exchanges

31.

A bond investor who is worried about future fluctuations in interest rates could: A. enter into a swap to pay both a fixed and a floating rate. B. enter into a swap to pay a fixed rate and receive a floating rate. C. enter into a swap to pay a floating rate and pay a fixed rate. D. enter into a swap to receive both a fixed and a floating rate. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

32.

Which one of the following is not generally considered a benefit of hedging? A. Hedging reduces business risk. B. Hedging allows prices to be locked in ahead of time. C. Hedging can be very profitable. D. Hedging can stabilize profits. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

33.

Which one of the following futures contracts is written on an asset that cannot be delivered? A. U.S. Treasury bills B. Wheat C. Standard and Poor's index D. British pounds AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

34.

How might a firm such as General Mills protect itself against fluctuations in raw material prices for breakfast cereals? A. Buy commodity futures B. Sell commodity futures C. Buy put options on commodities D. Sell put options on commodities AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic

Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

35.

The buyer of a credit default swap: A. gains protection against a fall in house prices. B. gains protection against default by a pension scheme. C. insures the seller against a fall in house prices. D. gains insurance against default on a bond. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

36.

What form of insurance would you suggest for a producer that wishes to be protected from future price decreases but wants to benefit from any future price increases? A. Buy a call option on the asset B. Sell a call option on the asset C. Buy a put option on the asset D. Sell a put option on the asset AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

37.

Which one of the following is not correct concerning futures contracts? A. Futures contracts entail an obligation rather than an option. B. The contract price is set at the beginning of the contract. C. The contracts are exchange-traded. D. Gains and losses are not settled until the contract expires. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

38.

Selling a futures contract may be appropriate for someone who wishes to: A. lock in a future sales price. B. lock in a future purchase price. C. speculate that future spot prices are going up. D. have a ready market in which to sell a product. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

39.

A speculator who buys a futures contract is betting that prices will _____ by the expiration of the contract. A. decrease B. increase C. remain constant D. guarantee high profits AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

40.

A speculator who sells a futures contract is betting that prices will _____ by the expiration of the contract. A. decrease B. increase C. remain constant D. Be unusually volatile AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

41.

What happens to the price of a futures contract as expiration draws closer? A. The futures price exceeds the spot price of the asset. B. The futures price is exceeded by the spot price of the asset. C. The futures price approaches the spot price of the asset. D. There is no relationship between the futures price and spot price as the contract approaches expiration. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

42.

When a commodity futures reaches its expiration, the seller usually: A. delivers the commodity to the futures buyer. B. delivers the commodity to the futures exchange. C. takes an offsetting futures position and settles in cash. D. adds the profit or loss to his margin account and continues to trade. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

43.

A commodity producer who is worried about future prices can best hedge by: A. buying a futures contract. B. selling a futures contract. C. buying a call option. D. selling a call option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

44.

A farmer sells corn futures for March delivery at $7.50 per bushel. In March the spot price of corn is $7.20 per bushel. Which of the following is correct? A. The futures buyer is required to deliver corn to the farmer at $7.20. B. The farmer has locked in an effective price of $7.50 per bushel. C. The farmer would have been better off without the futures contract. D. The farmer will receive $7.35 per bushel which is the average of the spot and futures prices. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

45.

A milling company buys a futures contract that requires it to take delivery of 5,000 bushels of wheat at a price of $6.80 per bushel. At expiration the spot price of wheat is $6.68 per bushel. The miller: A. has saved $0.12 per bushel through hedging. B. has locked in an effective price of $6.80 per bushel. C. can choose not to take delivery since the price declined. D. has locked in an effective price of $6.68 per bushel. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

46.

A milling company buys a futures contract that requires it to take delivery of 5,000 bushels of wheat at a price of $6.75 per bushel. Next day the price of the future is $6.80. The miller: A. must pay an extra $0.05 a bushel into its margin account. B. can withdraw $0.05 from its margin account. C. does not need to do anything until the contract matures. D. can’t say without knowing what happened to the spot price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

47.

Yesterday you sold six-month futures on the S&P index at a price of 2,100. Today the index closed at 2,050 and the future at 2,140. You get a call from your broker. Is he: A. asking you to pay $40 times the contract size into your margin account? B. asking you to pay $50 times the contract size into your margin account? C. telling you that you can withdraw $40 times the contract size from your margin account? D. telling you that you can withdraw $50 times the contract size from your margin account? AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

48.

Which one of the following would not be regulated in a standardized futures contract? A. Quantity of asset to be traded B. Quality of asset to be traded C. The spot price D. Date of settlement AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

49.

The purpose of a margin account for a futures contract is to: A. guarantee a minimum margin of profit for the contract holder. B. allow futures traders to have more than one contract simultaneously. C. provide a cushion for the exchange against defaults on the contract. D. hold interest payments until expiration. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

50.

The process of marking a futures contract to market means that: A. the profitability of the contract is locked in from the onset of the contract. B. the amount of commodity to be delivered changes as prices change. C. contracts are closed out as soon as they become unprofitable. D. profits or losses are settled daily. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

51.

A futures contract calls for delivery of 60,000 pounds of soybean oil. What happens to the seller of a soybean oil futures contract at 41 cents per pound if the futures price closes the next day at 42 cents per pound? A. The contract is marked to market with a $600 loss. B. The contract is marked to market with a $600 gain. C. Futures contracts are voided if the price increases prior to expiration. D. Nothing happens until the expiration of the contract. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

52.

A futures contract seller is obligated to deliver 5,000 bushels of soybeans for $12.00 per bushel at expiration. If soybean futures close at $12.10 the next day, the seller: A. has a profit of $500 thus far on the contract. B. has a loss of $500 thus far on the contract. C. has no profit or loss, but is still obligated to deliver 5,000 bushels at $12.00. D. will receive a check for $500 from the buyer of the contract. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

53.

What has happened to cause a $250 loss to be marked to the margin account of a futures contract buyer? A. The commodity futures price decreased on that day. B. The commodity futures price increased on that day. C. The commodity spot price decreased on that day. D. The commodity spot price increased on that day. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

54.

The effect of marking a futures contract to market is similar to: A. doubling the total payments by the contract buyer. B. doubling the total payments by the contract seller. C. closing the current position and opening a new position daily. D. imposing a daily fee on both buyers and sellers. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

55.

The primary purpose of financial futures is to: A. benefit from increases in interest rates. B. protect against swings in interest rates or prices of financial assets. C. translate one currency into another. D. guarantee the repayment of loan principal. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

56.

The basic difference between speculators and hedgers in futures contracts is that speculators: A. will profit regardless of the direction of price change. B. do not have an offsetting position in the underlying commodity. C. are concerned only with long-term price movements. D. take a position in more than one commodity at a time. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

57.

If there is an excess of market participants who want to buy the futures as a hedge, then: A. speculators will come into the market to sell the futures. B. speculators will see a potential profit from also buying the futures. C. speculators will steer clear of the futures market. D. the market may have to close down until there is a balance of supply and demand. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

58.

Which one of the following is not correct concerning forward contracts? Forward contracts: A. are not standardized. B. do not set the price until the end of the contract. C. are not traded on organized exchanges. D. are not marked to market daily. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

59.

You enter into a forward contract to take delivery of 1 million euros 3 months from now. What happens to the price you will pay at expiration if the euro depreciates during the contract period? A. Your price will increase. B. Your price will decrease. C. Your price was fixed at the onset of the contract. D. Your price was fixed but you will receive correspondingly more euros due to the depreciation. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

60.

Which one of the following is a reason for firms to engage in currency swaps? A. They will be required to repay only the interest. B. They can obtain more favorable terms by borrowing in a different currency. C. The debt will not show on their balance sheets. D. You can borrow in the currency with the lowest interest rate without taking on any currency risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic

Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

61.

When two borrowers engage in a currency swap, they agree to: A. a one-time currency exchange equal to the principal amount borrowed. B. make payments to each other in a different currency. C. pay to each other any depreciation or appreciation of the currency. D. exchange fixed-rate interest payments for variable-rate interest payments. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

62.

In an interest rate swap, borrowers typically exchange fixed-rate payments in one currency for: A. fixed-rate payments in another currency. B. variable-rate payments in another currency. C. fixed-rate payments in the same currency. D. variable-rate payments in the same currency. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

63.

ABC Corp. borrows $5 million at 10% from a bank and swaps this loan for a 12% yen loan. The spot exchange rate is JPY105 = USD1. How much does ABC pay annually to the bank? A. ¥1.26 million B. ¥5.71 million C. ¥52.50 million D. ¥63.00 million Annual interest payment = ($5 million × 105) × 0.12 = ¥63 million

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

64.

Which of the following statements is correct? A. Futures contracts and options contracts are economically similar, but vary in how they are traded. B. Forward contracts and futures contracts are economically similar, but vary in how they are traded. C. Forward contracts and options contracts are economically similar, but vary in how they are traded. D. Forward contracts, futures contracts, and options contracts are all economically similar, but vary in how they are traded. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

65.

The term derivatives refers to: A. forwards and futures. B. swaps and options. C. forwards, futures, swaps, and options. D. forwards, futures, and swaps. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

66.

A derivatives contract: A. increases the risk of both the hedger and speculator. B. increases the risk of the hedger and decreases the risk of the speculator. C. reduces the risk of the hedger and increases the risk of the speculator. D. reduces risk in both cases. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging

67.

Hershey's Chocolate is concerned about cocoa prices, which are currently $3,000 a ton. Analysts project that the cost of cocoa purchases could vary from $2,900 to $3,100 a ton. A September call option can be purchased with a $2,950 exercise price for $145. What is Hershey's worst-case scenario if it purchases these options? A. Cocoa prices will rise to $3,100 and Hershey is protected only to a price of $2,950. B. Cocoa prices will not change from their current level and Hershey will have wasted the cost of the option. C. Cocoa prices will not rise above Hershey's break-even price of $3,095, which equals the sum of the exercise price plus the cost of the option. D. Cocoa prices will fall below $2,950 and Hershey will lose the $145 cost of the option. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply

Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

68.

If you buy a forward contract, you agree to buy the product: A. at a later date at a price to be set in the future. B. today at its current price. C. at a later date at a price set today. D. if and only if its price rises above its exercise price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

69.

If you sell a forward contract, you agree to: A. deliver a product at a later date for a price set today. B. receive a product at a later date at the price on that later date. C. receive a product at a later date for a price set today. D. deliver a product at a later date for a price set on that later date. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

70.

One distinguishing difference between the buyer of a futures contract and the buyer of an option contract is that the futures buyer: A. pays a much higher up-front price than option buyers. B. has an obligation to purchase, not a choice. C. can lose no more than the initial outlay. D. has increased rather than reduced risk. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

71.

In general, when deciding whether one needs to buy or sell futures contracts in order to hedge, the rule could be: A. buy futures if you have the underlying asset and sell futures if you need the underlying asset. B. sell futures if you have the underlying asset and buy futures if you need the underlying asset. C. buy futures if you want to speculate, sell futures if you want to hedge. D. buy futures if you are willing to have unlimited risk, sell futures if you want capped risk. AACSB: Reflective Thinking

Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

72.

As time draws closer to contract expiration, futures prices can be expected to: A. increase as the demand for delivery intensifies. B. decrease as speculators resolve the uncertainty of prices. C. move similarly to broad-based market indices, such as the S&P 500. D. converge upon the spot price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

73.

Why are most futures contracts not settled through delivery of the product? A. Most contracts are settled through the margin account. B. Most contracts expire with neither party having an obligation to the other party. C. Most participants cancel their futures contracts through purchase of an option contract. D. It is easier and cheaper to settle in cash or by an offsetting futures transaction. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

74.

The price for immediate delivery of a product is called the: A. spot price. B. exercise price. C. forward price. D. the impact price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

75.

If you enter into an interest rate swap, the company taking the opposite side is called: A. The swap payer. B. The swap counterparty. C. The swap maker. D. The off-taker. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

76.

A gasoline distributor buys a gasoline futures contract to receive 42,000 gallons of gasoline at $2.94 per gallon. How is the account marked to market if gasoline futures close the next day at $2.97? A. A loss of $1,260 is posted to the account. B. A gain of $1,260 is posted to the account. C. A loss of $12,600 is posted to the account. D. A gain of $12,600 is posted to the account. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

77.

The seller of a pork bellies futures contract at $1.41 per pound noted that the closing price of pork bellies was $1.44 today. What will happen to this contract, which requires delivery of 40,000 pounds of pork bellies at expiration? A. A loss of $400 is posted to the account. B. A gain of $400 is posted to the account. C. A loss of $1,200 is posted to the account. D. A gain of $1,200 is posted to the account. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

78.

The typical sequence of cash flows in a futures contract is: A. purchase price plus a margin account up-front, differences are settled at expiration. B. margin account up-front, differences are posted daily and settled in cash if margin drops too low. C. margin account up-front, all differences settled at expiration. D. all funds are paid at expiration of the contract. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium

Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

79.

The seller of a copper futures contract noticed that his account was marked with a $500 gain yesterday. If the standardized contract requires delivery of 25,000 pounds of copper, what happened that day to the price of copper? A. The price closed down $0.02 per pound. B. The price closed up $0.02 per pound. C. The price closed down $0.20 per pound. D. The price closed up $0.20 per pound. Mark to market = $500 = $x × 25,000; x = $0.02; A seller of a futures contract gains when the closing price declines.

AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

80.

Which of the following contracts is not a financial future? A. eurodollar deposit futures B. yen futures C. orange juice futures D. Standard & Poor’s futures AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

81.

Which one of the following is not true of the financial futures markets? A. Financial futures trade on the Chicago Mercantile Exchange. B. When many financial future mature, the seller cannot deliver the asset to the buyer. C. A major use of financial futures is protection from interest rate risk. D. Trading in financial futures is significantly less than trading in financial futures. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Futures exchanges

82.

A clothes producer hedges its future cotton purchases by buying cotton futures. The futures contract provides the producer with 50,000 pounds of cotton at a price of $0.80 per pound. By contract expiration the producer finds that cotton prices have declined to $0.73 per pound. As a result of the futures contracts, the producer will: A. lose $3,500 per contract in the futures market which offsets gains in the cash market. B. gain $3,500 per contract in the futures market which offsets losses in the cash market. C. lose $3,500 per contract in the futures market and suffer an opportunity cost in the cash market. D. gain $3,500 per contract in the futures market and gain $0.07 per pound in the cash market. AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

83.

Which one of the following futures contract holders is speculating? A. A wheat farmer who sells wheat futures B. A cattle rancher who buys live cattle futures C. A candy maker who buys sugar futures D. An oil producer who sells crude oil futures AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

84.

The activities of speculators are necessary in the futures markets in order to: A. prevent hedgers from trading options. B. provide a continual stream of profit to hedgers. C. help ensure futures prices are fair value. D. understand the direction of future price changes. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

85.

Those who invest in derivative instruments that increase rather than reduce risk are known as: A. option traders. B. futures traders. C. hedgers. D. speculators. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy

Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Hedging

86.

Which one of the following characteristics is similar in both futures and forward contracts? A. Future transactions are conducted at a price agreed upon earlier. B. Contracts are sold through organized exchanges. C. Contract terms are standardized by type of commodity. D. Price changes are settled daily in a process known as mark-to-market. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

87.

A contract to buy Japanese yen three months forward at a price of ¥105/$ will: A. insulate the buyer from changes in interest rates. B. protect the buyer from changes in exchange rates. C. lock in a profit based on current exchange rates. D. require delivery of the yen at the Nasdaq Exchange. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

88.

Zeta Corp wishes to obtain a loan denominated in Swiss francs but the U.S. market offers better credit terms. What should Zeta do? A. Borrow francs in Switzerland, exchange for dollars, and arrange a currency swap. B. Borrow francs in Switzerland, exchange for dollars, and arrange an interest rate swap. C. Borrow dollars in the United States, exchange for francs, and arrange an interest rate swap. D. Borrow dollars in the United States, exchange for francs, and arrange a currency swap. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

89.

Currency swaps are used to: A. lock in an exchange rate for future delivery of a foreign currency. B. effectively transform loans originated in one currency to a different currency. C. transform fixed-rate loans into variable-rate loans. D. exchange foreign currencies in amounts not possible in the foreign exchange market. AACSB: Reflective Thinking Accessibility: Keyboard Navigation

Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

90.

On $10 million of loans, Firm A is paying a fixed $700,000 in interest payments while Firm B is paying LIBOR plus 50 basis points. The current LIBOR rate is 6.25 percent. Firms A and B have agreed to swap interest payments. How much will be paid to which firm this year? A. A pays $750,000 to Firm B. B. B pays $25,000 to Firm A. C. B pays $50,000 to Firm A. D. A pays $25,000 to Firm B. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued. Topic: Hedging with swap contracts

91.

Four investors buy sugar futures. Three are speculators and one is hedging. Which of the following is hedging? A. wheat farmer B. mutual fund C. soft drink producer D. none of the options AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging

92.

A firm can reduce the risk of upward movement in raw material prices by: A. buying a call option. B. selling a put option. C. buying a put option. D. selling a futures contract. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

93.

A farmer can hedge the risk of downward movement in the price of his product by: A. buying a call option. B. selling a put option. C. buying a put option. D. buying a futures contract. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with option contracts

94.

A sensible corporate risk strategy needs answers to three of these questions. Which is the odd man out? A. What are the major risks that the company faces? B. Is the company being paid for taking these risks? C. Can we spot any mispriced derivative contracts? D. Can the company reduce the probability of a bad outcome? AACSB: Analytical Thinking Accessibility: Keyboard Navigation Blooms: Analyze Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Risk management

95.

A farmer hedged his risk by buying put options on wheat with an exercise price of $6.70 at a price of $0.14 per bushel. If the price of wheat at the expiration of the contract is $6.70, what is the net revenue from each bushel of wheat? A. $6.56 B. $6.63 C. $6.70 D. $6.84 Net revenue = −$0.14 + 0 + $6.70 = $6.56 Net revenue = −cost of option + option payoff + price of wheat

96.

Which of the following strategies does not reduce risk? A. building flexibility into the firm’s operations B. increasing the proportion of the firm’s costs that are fixed C. taking out an insurance policy D. hedging with derivative contracts AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Risk management

97.

Which of these statements is not true? A. Transactions to reduce risk are unlikely to add value if investors can easily undertake similar transactions. B. Hedging may reduce the costs of financial distress. C. Transactions to reduce risk always add value. D. Hedging is a zero-sum game. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-01 Understand why companies hedge to reduce risk. Topic: Risk management

98.

Which one of the following statements is correct? A. An option seller makes more profits than an option buyer. B. A futures seller makes more profits than a futures buyer. C. The profit realized by the buyer of futures will be equal to the loss incurred by the seller. D. Both the buyer and the seller of a futures contract can earn a profit. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

99.

The most active trading in forward contracts is in: A. U.S. Treasury bills. B. the Standard and Poor's index. C. wheat crops. D. foreign currencies. AACSB: Communication Accessibility: Keyboard Navigation Blooms: Remember Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

100.

At the expiration of a futures contract, the futures price will be: A. greater than the spot price. B. equal to the spot price. C. less than the spot price. D. greater than the forward price. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Understand Difficulty: 1 Easy Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with futures contracts

101.

Which one of the following is the major difference between forward and futures contracts? A. Futures contracts are more expensive than forward contracts. B. Forward contracts are traded on the forward exchanges. C. Futures contracts are always delivered. D. Forward contracts are not marked to market. AACSB: Reflective Thinking Accessibility: Keyboard Navigation Blooms: Apply Difficulty: 2 Medium Gradable: automatic Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies. Topic: Hedging with forward contracts

Chapter 24 Test bank - Static Summary Category

# of Questions

AACSB: Analytical Thinking

AACSB: Communication

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

101

Blooms: Analyze

Blooms: Apply

Blooms: Remember

Blooms: Understand

Difficulty: 1 Easy

Difficulty: 2 Medium

Gradable: automatic

101

Learning Objective: 24-01 Understand why companies hedge to reduce risk.

Learning Objective: 24-02 Use options, futures, and forward contracts to devise simple hedging strategies.

Learning Objective: 24-03 Explain how companies can use swaps to change the risk of securities that they have issued.

Topic: Futures exchanges

Topic: Hedging

Topic: Hedging with forward contracts

Topic: Hedging with futures contracts

Topic: Hedging with option contracts

Topic: Hedging with swap contracts

Topic: Risk management