1) Hernandez Corporation expects to have the following data during the coming year.
What is Hernandez’s expected ROE?
Assets$200,000Interest rate8%
D/A65%Tax rate40%
EBIT$25,000
a.12.51%
b.13.14%
c.13.80%
d.14.49%
e.15.21%
2) A firm wants to strengthen its financial position. Which of the following actions
would increase its quick ratio?
a. Issue new common stock and use the proceeds to acquire additional fixed assets
b. Offer price reductions along with generous credit terms that would (1) enable the
firm to sell some of its excess inventory and (2) lead to an increase in accounts
receivable
c. Issue new common stock and use the proceeds to increase inventories
d. Speed up the collection of receivables and use the cash generated to increase
inventories
e. Use some of its cash to purchase additional inventories
3) Which of the following statements is CORRECT?
a.In the statement of cash flows, a decrease in accounts receivable is reported as a use
of cash
b.Dividends do not show up in the statement of cash flows because dividends are
considered to be a financing activity, not an operating activity
c.In the statement of cash flows, a decrease in accounts payable is reported as a use of
cash
d.In the statement of cash flows, depreciation charges are reported as a use of cash
e.In the statement of cash flows, a decrease in inventories is reported as a use of cash
4) A share of Lash Inc.’s common stock just paid a dividend of $1.00. If the expected
long-run growth rate for this stock is 5.4%, and if investors’ required rate of return is
11.4%, what is the stock price?
a.$16.28
b.$16.70
c.$17.13
d.$17.57
e.$18.01
5) Which of the following statements is CORRECT?
a.Electric utilities generally have very high common equity ratios because their
revenues are more volatile than those of firms in most other industries
b.Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios
because their earnings are very stable and, thus, they can cover the high interest costs
associated with high debt levels
c.Wide variations in capital structures exist both between industries and among
individual firms within given industries. These differences are caused by differing
business risks and also managerial attitudes
d.Since most stocks sell at or very close to their book values, book value capital
structures are almost always adequate for use in estimating firms’ costs of capital
e.Generally, debt-to-total-assets ratios do not vary much among different industries,
although they do vary among firms within a given industry
6) A 25-year, $1,000 par value bond has an 8.5% annual coupon. The bond currently
sells for $875. If the yield to maturity remains at its current rate, what will the price be
5 years from now?
a.$839.31
b.$860.83
c.$882.90
d.$904.97
e.$927.60
7) Which of the following statements is CORRECT?
a. If Apple issues additional shares of common stock through an investment banker, this
would be a secondary market transaction
b. If you purchased 100 shares of Apple stock from your sister-in-law, this would be an
example of a primary market transaction
c. The IPO market is a subset of the secondary market
d. Only institutions, and not individuals, can participate in derivatives market
transactions
e. As they are generally defined, money market transactions involve debt securities with
maturities of less than one year
8) Stock A’s beta is 1.7 and Stock B’s beta is 0.7. Which of the following statements
must be true, assuming the CAPM is correct.
a.In equilibrium, the expected return on Stock B will be greater than that on Stock A
b.When held in isolation, Stock A has more risk than Stock B
c.Stock B would be a more desirable addition to a portfolio than A
d.In equilibrium, the expected return on Stock A will be greater than that on B
e.Stock A would be a more desirable addition to a portfolio then Stock B
9) Suppose one U.S. dollar can purchase 144 yen today in the foreign exchange market.
If the yen depreciates by 8.0% tomorrow, how many yen could one U.S. dollar buy
tomorrow?
a.155.5 yen
b.144.0 yen
c.133.5 yen
d.78.0 yen
e.72.0 yen
10) Which of the following statements is CORRECT?
a.The DCF model is generally preferred by academics and financial executives over
other models for estimating the cost of equity. This is because of the DCF model’s
logical appeal and also because accurate estimates for its key inputs, the dividend yield
and the growth rate, are easy to obtain
b.The bond-yield-plus-risk-premium approach to estimating the cost of equity may not
always be accurate, but it has the advantage that its two key inputs, the firm’s own cost
of debt and its risk premium, can be found by using standardized and objective
procedures
c.Surveys indicate that the CAPM is the most widely used method for estimating the
cost of equity. However, other methods are also used because CAPM estimates may be
subject to error, and people like to use different methods as checks on one another. If all
of the methods produce similar results, this increases the decision maker’s confidence in
the estimated cost of equity
d.The DCF model is preferred by academics and finance practitioners over other cost of
capital models because it correctly recognizes that the expected return on a stock
consists of a dividend yield plus an expected capital gains yield
e.Although some methods used to estimate the cost of equity are subject to severe
limitations, the CAPM is a simple, straightforward, and reliable model that consistently
produces accurate cost of equity estimates. In particular, academics and corporate
finance people generally agree that its key inputsbeta, the risk-free rate, and the market
risk premiumcan be estimated with little error
11) Danielle’s Sushi Shop last year had (1) a negative net cash flow from operations, (2)
a negative free cash flow, and (3) an increase in cash as reported on its balance sheet.
Which of the following factors could explain this situation?
a.The company had a sharp increase in its depreciation and amortization expenses
b.The company had a sharp increase in its inventories
c.The company had a sharp increase in its accrued liabilities
d.The company sold a new issue of common stock
e.The company made a large capital investment early in the year
12) Which of the following statements is CORRECT?
a.The capital structure that maximizes the stock price is generally the capital structure
that also maximizes earnings per share
b.All else equal, an increase in the corporate tax rate would tend to encourage a
company to increase its debt ratio
c.Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio
will always increase its WACC
d.Since debt is cheaper than equity, increasing a company’s debt ratio will always
reduce its WACC
e.When a company increases its debt ratio, the costs of equity and debt both increase.
Therefore, the WACC must also increase
13) Modern Refurbishing Inc. is considering a project that has the following cash flow
data. What is the project’s IRR? Note that a project’s IRR can be less than the WACC
(and even negative), in which case it will be rejected.
Year01234
Cash flows-$850$300$290$280$270
a.13.13%
b.14.44%
c.15.89%
d.17.48%
e.19.22%
14) Spot-Free Car Wash is considering a new project whose data are shown below. The
equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis
over the project’s 3-year life, and would have a zero salvage value after Year 3. No new
working capital would be required. Revenues and other operating costs will be constant
over the project’s life, and this is just one of the firm’s many projects, so any losses on it
can be used to offset profits in other units. If the number of cars washed declined by
40% from the expected level, by how much would the project’s NPV decline? (Hint:
Note that cash flows are constant at the Year 1 level, whatever that level is.)
WACC10.0%
Net investment cost (depreciable basis)$60,000
Number of cars washed2,800
Average price per car$25.00
Fixed op. cost (excl. deprec.)$10,000
Variable op. cost/unit (i.e., VC per car washed)$5.375
Annual depreciation$20,000
Tax rate35.0%
a.$28,939
b.$30,462
c.$32,066
d.$33,753
e.$35,530
15) Which of the following is NOT a reason why companies move into international
operations?
a.To develop new markets for the firm’s products
b.To better serve their primary customers
c.Because important raw materials are located abroad
d.To increase their inventory levels
e.To take advantage of lower production costs in regions where labor costs are
relatively low
16) You have just landed an internship in the CFO’s office of Hawkesworth Inc. Your
first task is to estimate the Year 1 cash flow for a project with the following data. What
is the Year 1 cash flow?
Sales revenues$13,000
Depreciation$4,000
Other operating costs$6,000
Tax rate35.0%
a.$5,950
b.$6,099
c.$6,251
d.$6,407
e.$6,568
17) Craig’s Car Wash Inc. is considering a project that has the following cash flow and
WACC data. What is the project’s discounted payback?
WACC:10.00%
Year0123
Cash flows-$900$500$500$500
a.1.88 years
b.2.09 years
c.2.29 years
d.2.52 years
e.2.78 years
18) Which of the following is NOT directly reflected in the cash budget of a firm that is
in the zero tax bracket?
a.Depreciation
b.Cumulative cash
c.Repurchases of common stock
d.Payment for plant construction
e.Payments lags
19) Other things held constant, which of the following would tend to reduce the cash
conversion cycle?
a.Place larger orders for raw materials to take advantage of price breaks
b.Take all discounts that are offered
c.Continue to take all discounts that are offered and pay on the net date
d.Offer longer payment terms to customers
e.Carry a constant amount of receivables as sales decline
20) Portfolio P has equal amounts invested in each of the three stocks, A, B, and C.
Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Each
of the stocks has a standard deviation of 25%. The returns on the three stocks are
independent of one another (i.e., the correlation coefficients all equal zero). Assume that
there is an increase in the market risk premium, but the risk-free rate remains
unchanged. Which of the following statements is CORRECT?
a.The required return on Stock A will increase by less than the increase in the market
risk premium, while the required return on Stock C will increase by more than the
increase in the market risk premium
b.The required return on the average stock will remain unchanged, but the returns of
riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as
Stock A) will decrease
c.The required returns on all three stocks will increase by the amount of the increase in
the market risk premium
d.The required return on the average stock will remain unchanged, but the returns on
riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as
Stock A) will increase
e.The required return of all stocks will remain unchanged since there was no change in
their betas
21) Julia Saunders is your boss and the treasurer of Foster Carter Enterprises (FCE).
She asked you to help her estimate the intrinsic value of the company’s stock. FCE just
paid a dividend of $1.00, and the stock now sells for $15.00 per share. Julia asked a
number of security analysts what they believe FCE’s future dividends will be, based on
their analysis of the company. The consensus is that the dividend will be increased by
10% during Years 1 to 3, and it will be increased at a rate of 5% per year in Year 4 and
thereafter. Julia asked you to use that information to estimate the required rate of return
on the stock, rs, and she provided you with the following template for use in the
analysis:
Julia told you that the growth rates in the template were just put in as a trial, and that
you must replace them with the analysts’ forecasted rates to get the correct forecasted
dividends and then the estimated TV. She also notes that the estimated value for rs, at
the top of the template, is also just a guess, and you must replace it with a value that
will cause the Calculated Price shown at the bottom to equal the Actual Market Price.
She suggests that, after you have put in the correct dividends, you can manually
calculate the price, using a series of guesses as to the Estimated rs. The value of rs that
causes the calculated price to equal the actual price is the correct one. She notes,
though, that this trial-and-error process would be quite tedious, and that the correct rs
could be found much faster with a simple Excel model, especially if you use Goal Seek.
What is the value of rs?
a.11.84%
b.12.21%
c.12.58%
d.12.97%
e.13.36%
22) Stocks A and B both have an expected return of 10% and a standard deviation of
returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation
coefficient, r, between the two stocks is 0.6. Portfolio P has 50% invested in Stock A
and 50% invested in B. Which of the following statements is CORRECT?
a.Based on the information we are given, and assuming those are the views of the
marginal investor, it is apparent that the two stocks are in equilibrium
b.Portfolio P has more market risk than Stock A but less market risk than B
c.Stock A should have a higher expected return than Stock B as viewed by the marginal
investor
d.Portfolio P has a coefficient of variation equal to 2.5
e.Portfolio P has a standard deviation of 25% and a beta of 1.0
23) Whitson Co. is looking for ways to shorten its cash conversion cycle. It has annual
sales of $36,500,000, or $100,000 a day on a 365-day basis. The firm’s cost of goods
sold is 75% of sales. On average, the company has $9,000,000 in inventory and
$8,000,000 in accounts receivable. Its CFO has proposed new policies that would result
in a 20% reduction in both average inventories and accounts receivable. She also
anticipates that these policies would reduce sales by 10%, while the payables deferral
period would remain unchanged at 35 days. What effect would these policies have on
the company’s cash conversion cycle? Round to the nearest whole day.
a.-26 days
b.-22 days
c.-18 days
d.-14 days
e.-11 days
24) Refer to Exhibit 21.1. Assume now that the company believes that if it adopts a
restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets
turnover, debt ratio, interest rate, and tax rate will all remain the same. In this situation,
what’s the difference between the projected ROEs under the restricted and relaxed
policies?
a.2.24%
b.2.46%
c.2.70%
d.2.98%
e.3.27%
25) Which of the following statements is CORRECT?
a.In managing a firm’s accounts receivable, it is possible to increase credit sales per day
yet still keep accounts receivable fairly steady, provided the firm can shorten the length
of its collection period (its DSO) sufficiently
b.Because of the costs of granting credit, it is not possible for credit sales to be more
profitable than cash sales.
c.Since receivables and payables both result from sales transactions, a firm with a high
receivables-to-sales ratio must also have a high payables-to-sales ratio
d.Other things held constant, if a firm can shorten its DSO, this will lead to a higher
current ratio
e.A firm that makes 90% of its sales on credit and 10% for cash is growing at a constant
rate of 10% annually. Such a firm will be able to keep its accounts receivable at the
current level, since the 10% cash sales can be used to finance the 10% growth rate
26) Which of the following statements is CORRECT?
a. In a regular partnership, liability for other partners’ misdeeds is limited to the amount
of a particular partner’s investment in the business
b. Attracting large amounts of capital is more difficult for partnerships than for
corporations because of such factors as unlimited liability, the need to reorganize when
a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests
c. A slow-growth company, with little need for new capital, would be more likely to
organize as a corporation than would a faster growing company
d. The limited partners in a limited partnership have voting control, while the general
partner has operating control over the business. Also, the limited partners are
individually responsible, on a pro rata basis, for the firm’s debts in the event of
bankruptcy
e. A major disadvantage of all partnerships compared to all corporations is the fact that
federal income taxes must be paid by the partners rather than by the firm itself
27) Barker Corp. has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a
3.00% future inflation rate, and the market risk premium is 4.70%. What is Barker’s
required rate of return?
a.9.43%
b.9.67%
c.9.92%
d.10.17%
e.10.42%
28) Which of the following statements is CORRECT?
a.Projects with “normal” cash flows can have two or more real IRRs
b.Projects with “normal” cash flows must have two changes in the sign of the cash
flows, e.g., from negative to positive to negative. If there are more than two sign
changes, then the cash flow stream is “nonnormal.”
c.The “multiple IRR problem” can arise if a project’s cash flows are “normal.”
d.Projects with “nonnormal” cash flows are almost never encountered in the real world
e.Projects with “normal” cash flows can have only one real IRR
29) To increase productive capacity, a company is considering a proposed new plant.
Which of the following statements is CORRECT?
a.Since depreciation is a non-cash expense, the firm does not need to deal with
depreciation when calculating the operating cash flows
b.When estimating the project’s operating cash flows, it is important to include both
opportunity costs and sunk costs, but the firm should ignore the cash flow effects of
externalities since they are accounted for in the discounting process
c.Capital budgeting decisions should be based on before-tax cash flows
d.The WACC used to discount cash flows in a capital budgeting analysis should be
calculated on a before-tax basis
e.In calculating the project’s operating cash flows, the firm should not deduct financing
costs such as interest expense, because financing costs are accounted for by discounting
at the WACC. If interest were deducted when estimating cash flows, this would, in
effect, “double count” it
30) Stocks A and B have the same price and are in equilibrium, but Stock A has the
higher required rate of return. Which of the following statements is CORRECT?
a.Stock B must have a higher dividend yield than Stock A
b.Stock A must have a higher dividend yield than Stock B
c.If Stock A has a higher dividend yield than Stock B, its expected capital gains yield
must be lower than Stock B’s
d.Stock A must have both a higher dividend yield and a higher capital gains yield than
Stock B
e.If Stock A has a lower dividend yield than Stock B, its expected capital gains yield
must be higher than Stock B’s
31) The before-tax cost of debt, which is lower than the after-tax cost, is used as the
component cost of debt for purposes of developing the firm’s WACC.
32) Since the market return represents the expected return on an average stock, the
market return reflects a certain amount of risk. As a result, there exists a market risk
premium, which is the amount over and above the risk-free rate, that is required to
compensate stock investors for assuming an average amount of risk.
33) There are three primary disadvantages of a regular partnership: (1) unlimited
liability, (2) limited life of the organization, and (3) difficulty of transferring ownership.
These combine to make it difficult for partnerships to attract large amounts of capital
and thus to grow to a very large size.
34) The phenomenon called “multiple internal rates of return” arises when two or more
mutually exclusive projects that have different lives are compared to one another.
35) The times-interest-earned ratio is one, but not the only, indication of a firm’s ability
to meet its long-term and short-term debt obligations.
36) The primary advantage to using accelerated rather than straight-line depreciation is
that with accelerated depreciation the total amount of depreciation that can be taken,
assuming the asset is used for its full tax life, is greater.
37) The fact that 70% of the interest income received by a corporation is excluded from
its taxable income encourages firms to use more debt financing than they would in the
absence of this tax law provision.
38) If an investor can obtain more of a foreign currency for a dollar in the forward
market than in the spot market, then the forward currency is said to be selling at a
discount to the spot rate.