Principles of Finance, 6e
Besley/Brigham
Chapter 10
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1. Assuming g will remain constant, the dividend yield is a good measure of the required return on a common stock under
which of the following circumstances?
a.
g = 0.
b.
g > 0.
c.
g < 0.
d.
Under no circumstances.
e.
Answers a and b are both correct.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Dividend Yield and g
2. An increase in a firm’s expected growth rate would normally cause the firm’s required rate of return to
a.
Increase.
b.
Decrease.
c.
Fluctuate.
d.
Remain constant.
e.
Possibly increase, possibly decrease, or possibly remain unchanged.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Required Return
3. If the expected rate of return on a stock exceeds the required rate,
a.
b.
c.
d.
e.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Principles of Finance, 6e
Besley/Brigham
Chapter 10
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6. Which of the following statements is correct?
a.
The constant growth DCF model can be used to value a stock only if the stock’s dividends are expected to
grow forever at a constant rate which is less than the required rate of return on the stock.
b.
If the growth rate is negative, the constant growth DCF model cannot be used.
c.
The constant growth DCF model may be written as r0 = D0/P0 + g.
d.
The constant growth DCF model may be written as P0 = D0/(r + g).
e.
The constant growth DCF model may be written as P0 = D0/(r − g).
ANSWER:
a
RATIONALE:
Statement a is the condition necessary for the constant growth model. All the other
statements are false.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Constant Growth Model
7. Which of the following statements is correct?
a.
Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond.
b.
Other things held constant, a corporation would rather issue noncallable bonds than callable bonds.
c.
Reinvestment rate risk is worse from a typical investor’s standpoint than interest rate price risk.
d.
If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a 10 percent rate of
return, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond
would sell at a premium over its $1,000 par value.
e.
If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a 10 percent rate of
return, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond
would sell at a discount below its $1,000 par value.
ANSWER:
e
RATIONALE:
A zero coupon bond will always sell at a discount below par, provided interest rates are
above zero, which they always are.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Bonds
8. Which of the following statements is correct?
Principles of Finance, 6e
Besley/Brigham
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a.
Bond prices and interest rates move in the same direction, i.e., if interest rates rise, so will bond prices.
b.
The market price of a discount bond will approach the bond’s par value as the maturity date approaches.
Barring changes in the probability of default, there is no way the value of the bond can fail to increase each
year as the time to maturity approaches.
c.
The “current yield” on a noncallable discount bond will normally exceed the bond’s yield to maturity.
d.
The “current yield” on a noncallable discount bond will normally exceed the bond’s coupon interest rate.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Discount Bond
9. Which of the following statements is correct?
a.
Rising inflation makes the actual yield to maturity on a bond greater than the quoted yield to maturity which is
based on market prices.
b.
The yield to maturity for a coupon bond that sells at its par value consists entirely of an interest yield; it has a
zero expected capital gains yield.
c.
On an expected yield basis, the expected capital gains yield will always be positive because an investor would
not purchase a bond with an expected capital loss.
d.
The market value of a bond will always approach its par value as its maturity date approaches. This holds true
even if the firm enters bankruptcy.
e.
All of the above statements are false.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Bond Yield
10. Which of the following statements is most correct?
a.
The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield
to maturity than Bond B.
b.
If a bond is selling at a discount, the current yield is a better measure of return than the yield to maturity.
c.
If a coupon bond is selling at par, its current yield equals its yield to maturity.
d.
Both a and b are correct.
e.
Both b and c are correct.
ANSWER:
c
Principles of Finance, 6e
Besley/Brigham
Chapter 10
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d.
The value of the stock could be found by DCF procedures, but we would have to insert zeros for until such
time as we expect the company to begin paying dividends.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Stock Valuation
13. Which of the following is not true about bonds? In all of the statements, assume other things are held constant.
a.
Price sensitivity, that is, the change in price due to a given change in the required rate of return, increases as a
bond’s maturity increases.
b.
For a given bond of any maturity, a given percentage point increase in the interest rate (rd) causes a larger
dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.
c.
For any given maturity, a given percentage point increase in the interest rate causes a smaller dollar capital
loss than the capital gain stemming from an identical decrease in the interest rate.
d.
From a borrower’s point of view, interest paid on bonds is tax-deductible.
e.
A 20-year zero-coupon bond has less reinvestment rate risk than a 20-year coupon bond.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Bonds
14. If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the largest percentage increase
in its value?
a.
A 10-year zero-coupon bond.
b.
A 10-year bond with a 10 percent semiannual coupon.
c.
A 10-year bond with a 10 percent annual coupon.
d.
A 5-year zero-coupon bond.
e.
A 5-year bond with a 12 percent annual coupon.
ANSWER:
a
RATIONALE:
Statement a is correct. The present value of the 10-year, zero-coupon bond at an 8
percent interest rate is $463.19, while its value at a 7 percent interest rate is $508.34.
The percentage change is $45.15/$463.19 = 9.75%. If you work out the other percentage
increases in values due to the change in interest rates, you’ll obtain the following results:
b.
10-year, 10% semiannual coupon: 6.80%.
Principles of Finance, 6e
Besley/Brigham
Chapter 10
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e.
Answers a and c are both correct.
ANSWER:
e
RATIONALE:
Statements a and c are correct; therefore, statement e is the correct choice. The longer
the maturity of a bond, the greater the impact an increase in interest rates will have on
the bond’s price. Statement b is false. To see this, assume interest rates increase from 7
percent to 10 percent. Evaluate the change in the prices of a 10-year, 5 percent coupon
bond and a 10-year, 12 percent coupon bond. The 5 percent coupon bond‘s price
decreases by 19.4 percent, while the 12 percent coupon bond’s price decreases by only
16.9 percent. Statement c is correct. To see this, evaluate a 10-year, zero-coupon bond
and a 9-year, 10 percent annual coupon bond at 2 different interest rates, say 7 percent
and 10 percent. The zero-coupon bond’s price decreases by 24.16 percent, while the 9-
year, 10 percent coupon bond’s price decreases by only 16.33 percent.
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-01 – Stocks and Bonds
DISC-FIN-04 – International Financial Management
Time Estimate-a – 5 min.
TOPICS:
Bond Concepts
17. Which of the following statements is correct?
a.
A 10-year bond would have more interest rate price risk than a 5-year bond, but all 10-year bonds have the
same interest rate price risk.
b.
A 10-year bond would have more reinvestment rate risk than a 5-year bond, but all 10-year bonds have the
same reinvestment rate risk.
c.
If their maturities were the same, a 5 percent coupon bond would have more interest rate price risk than a 10
percent coupon bond.
d.
If their maturities were the same, a 5 percent coupon bond would have less interest rate price risk than a 10
percent coupon bond.
e.
Zero-coupon bonds have more interest rate price risk than any other type bond, even perpetuities.
ANSWER:
c
RATIONALE:
Statement c is correct. For example, assume these coupon bonds have 10 years until
maturity and the current interest rate is 12 percent. The 5 percent coupon bond’s value is
$604.48, while the 10 percent coupon bond’s value is $887.00. Thus, the lower coupon
bond has more price risk than the higher coupon bond. The lower the coupon, the greater
the percentage of the cash flow that will come in the later years (from the maturity value),
hence, the greater the impact of interest rate changes. Statement a is false⎯as we
demonstrated above. Statement b is false⎯shorter-term bonds have more reinvestment
rate risk than longer-term bonds because the principal payment must be reinvested
sooner on the shorter-term bond. Statement d is false⎯as we demonstrated earlier.
Statement e is false because perpetuities have no maturity date; therefore, they have
more price risk than zero-coupon bonds. The longer a security’s maturity, the greater its
price risk.
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
Principles of Finance, 6e
Besley/Brigham
Chapter 10
Cengage Learning Testing, Powered by Cognero
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25. A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently $50, what
is the simple annual rate of return?
a.
12%
b.
18%
c.
20%
d.
23%
e.
28%
ANSWER:
c
RATIONALE:
Annual dividend = $2.50(4) = $10. rps = Dps/Vps = $10/$50 = 0.20 = 20%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Preferred Stock Yield
26. A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00 for this preferred
stock, what is your simple (not effective) annual rate of return?
a.
10%
b.
8%
c.
6%
d.
12%
e.
14%
ANSWER:
a
RATIONALE:
Yearly dividend = $0.50(4) = $2.00. rps = Dps/Vps = $2.00/$20.00 = 0.10 = 10%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Preferred Stock Yield
27. Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will
not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you
expect to sell the stock for $150 at the end of Year 2. If your expected rate of return is 16 percent, how much should you
be willing to pay for this stock today?
a.
$164.19
b.
$75.29
c.
$107.53
d.
$118.35
e.
$131.74
Principles of Finance, 6e
Besley/Brigham
Chapter 10
e.
$175.83
ANSWER:
d
RATIONALE:
Cash flow time line: Numerical solution:
Financial calculator solution: Inputs: N = 2; I = 16; FV = 159.25.
Output: PV = −$118.35. = $118.35.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Stock Value
28. The last dividend on Spirex Corporation’s common stock was $4.00, and the expected growth rate is 10 percent. If you
require a rate of return of 20 percent, what is the highest price you should be willing to pay for this stock?
a.
$44.00
b.
$38.50
c.
$40.00
d.
$45.69
e.
$50.00
ANSWER:
a
RATIONALE:
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Stock Price
29. You are trying to determine the appropriate price to pay for a share of common stock. If you purchase this stock, you
plan to hold it for 1 year. At the end of the year you expect to receive a dividend of $5.50 and to sell the stock for $154.
The appropriate rate of return for this stock is 16 percent. What should be the current price of this stock?
a.
$137.50
b.
$150.22
c.
$162.18
d.
$98.25
Principles of Finance, 6e
Besley/Brigham
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ANSWER:
a
RATIONALE:
Cash flow time line: P0 = ? rs = 16% D1 = 5.50 P1 = 154.00
CF1 = 5.50 + 154.00 = 159.50 Numerical solution:
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Stock Price
30. A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 15
percent, and if investors require a 19 percent rate of return, what is the price of the stock?
a.
$57.50
b.
$62.25
c.
$71.86
d.
$64.00
e.
$44.92
ANSWER:
a
RATIONALE:
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Constant Growth Stock
31. A share of common stock has a current price of $82.50 and is expected to grow at a constant rate of 10 percent. If you
require a 14 percent rate of return, what is the current dividend on this stock?
a.
$3.00
b.
$3.81
c.
$4.29
d.
$4.75
e.
$6.13
ANSWER:
a
Principles of Finance, 6e
Besley/Brigham
Chapter 10
appears that the first 4 years represented a supernormal growth situation and since then a more normal growth rate has
been sustained. What are the rates of growth for the earlier period and for the later period?
a.
6%; 5%
b.
6%; 3%
c.
10%; 8%
d.
10%; 5%
e.
12%; 7%
ANSWER:
d
RATIONALE:
Equation solution:
Financial calculator solution: Inputs: N = 4; PV = −0.26; FV = 0.38. Output: I = 9.95% ≈
10%. Inputs: N = 7; PV = −0.38; FV = 0.535. Output: I = 5.01% ≈ 5%. Cash flow time line:
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Growth Rate
34. Assume that a 15-year, $1,000 face value bond pays interest of $37.50 every 3 months. If you require a simple annual
rate of return of 12 percent, with quarterly compounding, how much should you be willing to pay for this bond?
a.
$821.92
b.
$1,207.57
c.
$986.43
d.
$1,120.71
e.
$1,358.24
ANSWER:
b
RATIONALE:
Equation solution:
Financial calculator solution: Inputs: N = 60; I = 3; PMT = 37.50; FV = 1,000. Output: PV
Principles of Finance, 6e
Besley/Brigham
Chapter 10
a.
$5,412,000
b.
$5,480,000
c.
$2,531,000
d.
$7,706,000
e.
$7,056,000
being paid semiannually. The required simple rate on this debt has now risen to 16 percent. What is the current value of
this bond?
a.
$1,273
b.
$1,000
c.
$7,783
d.
$550
e.
$450
ANSWER:
d
RATIONALE:
Equation solution:
Financial calculator solution: Inputs: N = 30; I = 8; PMT = 40; FV = 1,000. Output: PV =
−$549.69; Vd = $549.69 ≈ $550. Cash flow time line:
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Bond Value – Semiannual Payment
37. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures to a
market value basis. KJM Corporation’s balance sheet as of January 1, 2010 is as follows:
Long-term debt (bonds, at par)
$10,000,000
Preferred stock
2,000,000
Common stock ($10 par)
10,000,000
Retained earnings
4,000,000
Total debt and equity
$26,000,000
The bonds have a 4 percent coupon rate, payable semiannually, and a par value of $1,000. They mature on January 1,
2020. The yield to maturity is 12 percent, so the bonds now sell below par. What is the current market value of the firm’s
Principles of Finance, 6e
Besley/Brigham
Chapter 10
ANSWER:
a
RATIONALE:
Equation solution:
Since there
are 10,000 bonds outstanding the total value of debt is $541.20(10,000) = $5.412 million.
Financial calculator solution: Inputs: N = 20; I = 6; PMT = 20; FV = 1,000. Output: PV =
−$541.20; Vd = $541.20. Cash flow time line:
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-01 – Stocks and Bonds
Time Estimate-a – 5 min.
TOPICS:
Market Value of Bonds
38. You are the owner of 100 bonds issued by Euler, Ltd. These bonds have 8 years remaining to maturity, an annual
coupon payment of $80, and a par value of $1,000. Unfortunately, Euler is on the brink of bankruptcy. The creditors,
including yourself, have agreed to a postponement of the next 4 interest payments (otherwise, the next interest payment
would have been due in 1 year). The remaining interest payments, for Years 5 through 8, will be made as scheduled. The
postponed payments will accrue interest at an annual rate of 6 percent, and they will then be paid as a lump sum at
maturity 8 years hence. The required rate of return on these bonds, considering their substantial risk, is now 28 percent.
What is the present value of each bond?
a.
$538.21
b.
$426.73
c.
$384.84
d.
$266.88
e.
$249.98
ANSWER:
d