Use the information for the question(s) below.
If it is managed efficiently, Luther industries will have assets with market value of $100
million, $300, million, or $500 million next year, with each outcome being equally
likely. Managers may, however, engage in wasteful empire building which will reduce
the firm’s market value by $20 million in all cases. Managers may also increase the risk
of the firm, changing the probability of each outcome to 50%, 20%, and 30%
respectively.
If its managers engage in empire building, then the expected market value of Luther’s
assets is closest to:
A) $260
B) $280 million
C) $240
D) $300 million
If Flagstaff currently maintains a debt to equity ratio of 1, then Flagstaff’s after-tax
WACC is closest to:
A) 10.25%
B) 10.00%
C) 9.50%
D) 8.75%
Use the table for the question(s) below.
The following table summarizes prices of various default-free zero-coupon bonds
(expressed as a percentage of face value):
The yield to maturity for the two year zero-coupon bond is closest to:
A) 6.0%
B) 5.8%
C) 5.6%
D) 5.5%
Use the following information to answer the question(s) below.
All amounts are in millions.
The correlation between the expected return and the market capitalization of these
stocks is
A) negative.
B) positive.
C) zero.
D) Unable to determine with the information given
Which of the following statements is false?
A) The amount of each coupon payment is determined by the coupon rate of the bond.
B) Prior to its maturity date, the price of a zero-coupon bond is always greater than its
face value.
C) The simplest type of bond is a zero-coupon bond.
D) Treasury bills are U.S. government bonds with a maturity of up to one year.
Which of the following statements is false?
A) Rather than set debt according to a target debt-equity ratio or interest coverage level,
a firm may adjust its debt according to a fixed schedule that is known in advance.
B) When we relax the assumption of a constant debt-equity ratio, the equity cost of
capital and WACC for a project will change over time as the debt-equity ratio changes.
C) When we relax the assumption of a constant debt-equity ratio, the APV and FTE
methods are difficult to implement.
D) If a firm is using leverage to shield income from corporate taxes, then it will adjust
its debt level so that its interest expenses grow with its earnings.
Rearden Metals is considering opening a strip mining operation to provide some of the
raw materials needed in producing Rearden metal. The initial purchase of the land and
the associated costs of opening up mining operations will cost $100 million today. The
mine is expected to generate $16 million worth of ore per year for the next 12 years. At
the end of the 12th year Rearden will need to spend $20 million to restore the land to its
original pristine nature appearance.
The payback period for Rearden’s mining operation is closest to:
A) 5.00 years
B) 6.00 years
C) 6.25 years
D) 6.50 years
Use the information for the question(s) below.
Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a
corporate tax rate of 35%.
The amount of Rosewood’s interest tax shield is closest to:
A) $115 million
B) $290 million
C) $175 million
D) $60 million
Use the information for the question(s) below.
Rockwood Industries has 100 million shares outstanding, a current share price of $25,
and no debt. Rockwood’s management believes that the shares are under-priced, and
that the true value is $30 per share. Rockwood plans to pay $250 million in cash to its
shareholders by repurchasing shares. Management expects that very soon new
information will come out that will cause investors to revise their opinion of the firm
and agree with Rockwood’s assessment of the firm’s true value.
Assume that Rockwood is able to repurchase shares prior to the market becoming aware
of the new information regarding Rockwood’s true value. After the repurchase, and
following the release of the new information regarding the true value of Rockwood, the
firm’s share price is closest to:
A) $30.00
B) $31.50
C) $28.75
D) $30.60
Walgreen Company (NYSE: WAG) is currently trading at $48.75 on the NYSE.
Walgreen Company is also listed on NASDAQ and assume it is currently trading on
NASDAQ at $48.50. Does an arbitrage opportunity exists and if so how would you
exploit it and how much would you make on a block trade of 100 shares?
A) No, no arbitrage opportunity exists.
B) Yes, buy on NASDAQ and sell on NYSE, make $25.
C) Yes, buy on NYSE and sell on NASDAQ, make $25.
D) Yes, buy on NASDAQ and sell on NYSE, make $250.
Which of the following statements is false?
A) Mortgage-backed securities, such as GNMAs, are pass-throughsecurities. That is,
each security is backed by an underlying portfolio or poolof mortgages.
B) The Government National Mortgage Association (GNMA, or “Ginnie Mae”) is an
example of an enterprise; the Student Loan Marketing Association (“Sallie Mae”) is an
example of a government-sponsored agency.
C) Sovereign debt is debt issued by national governments.
D) Agency securitiesare issued by agencies of the U.S. government or by U.S.
government sponsored enterprises.
Use the table for the question(s) below.
Consider the following Price and Dividend data for General Electric Company:
Assume that you purchased General Electric Company stock at the closing price on
December 31, 2008 and sold it after the dividend had been paid at the closing price on
January 26, 2009. Your total return rate (yield) for this period is closest to:
A) 0.75%
B) -8.80%
C) 0.70%
D) -8.15%
Consider the following equation:
E + D = U = A
The E in this equation represents
A) the value of the firm’s equity.
B) the value of the firm’s debt.
C) the value of the firm’s unlevered equity.
D) the market value of the firm’s assets.
Which of the following statements is false?
A) Managers are much less committed to dividend payments than to share repurchases.
B) Share repurchases are a credible signal that the shares are under-priced, because if
they are over-priced a share repurchase is costly for current shareholders.
C) While an increase of a firm’s dividend may signal management’s optimism regarding
its future cash flows, it might also signal a lack of investment opportunities.
D) Managers will clearly be more likely to repurchase shares if they believe the stock to
be under-valued.
Which of the following statements is false?
A) The APV approach explicitly values the market imperfections and therefore allows
managers to measure their contribution to value.
B) We need to know the debt level to compute the APV, but with a constant debt-equity
ratio we need to know the project’s value to compute the debt level.
C) The WACC method is more complicated than the APV method because we must
compute two separate valuations: the unlevered project and the interest tax shield.
D) Implementing the APV approach with a constant debt-equity ratio requires solving
for the project’s debt and value simultaneously.
Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or
$117,000 in a strong economy, with each outcome being equally likely. The initial
investment required for the project is $80,000, and the project’s cost of capital is 15%.
The risk-free interest rate is 5%.
The NPV for this project is closest to:
A) $6,250
B) $14,100
C) $10,000
D) $18,600
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the
success of this product, MI will have a value of either $100 million, $150 million, or
$191 million, with each outcome being equally likely. The cash flows are unrelated to
the state of the economy (i.e. risk from the project is diversifiable) so that the project
has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.
Assume that the capital markets are perfect.
Assume that in the event of default, 20% of the value of MI’s assets will be lost in
bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face
value due next year. The present value of MI’s financial distress costs is closest to:
A) $20.0 million
B) $6.6 million
C) $6.3 million
D) $19.0 million
Use the table for the question(s) below.
Consider the following information on options from the CBOE for Merck:
How many of the January 2009 call options are in the money?
A) 2
B) 4
C) 1
D) 3
Use the following information to answer the question(s) below.
Wyatt Oil is considering an investment in a new project with an unlevered cost of
capital of 11%. Wyatt’s marginal corporate tax rate is 35% and its debt cost of capital is
6%. The project has free cash flows of $25 million per year which are expected to
decline by 3% per year.
If Wyatt adjusts its debt continuously to maintain a constant debt-equity ratio of 50%,
then the value of this new project is closest to:
A) $240 million
B) $320 million
C) $340 million
D) $445 million
Use the following information to answer the question(s) below.
(Please use a copy of the Cumulative Probabilities for the standard normal distribution
for these problems.)
Taggart Transcontinental’s stock has a volatility of 25% and a current stock price of $40
per share. Taggart pays no dividends. The risk-free interest rate is 4%.
Assuming the beta on Taggart stock is 0.75, then the beta for a one-year, at-the-money
put option on Taggart stock is closest to:
A) -0.75
B) -2.84
C) -3.89
D) -6.41
Suppose that you want to use the 10 year historical average return on Stock A to
forecast the expected future return on Stock A. The 95% confidence interval for your
estimate of the expect return is closest to:
A) 13.2% to 19.5%
B) 10.1% to 22.7%
C) 6.5% to 26.3%
D) -15.1% to 47.8%
Wyatt Oil just reported that a major fire destroyed one of its oil production facilities in
Colorado. While the facility was fully insured, the loss of oil production will decrease
Wyatt’s free cash flow by $120 million at the end of this year and by $80 million at the
end of next year. Wyatt has 50 million shares outstanding and has a weighted average
cost of capital of 9%. Assuming the value of Wyatt’s debt is not affected by this event,
the expected decrease in Wyatt’s stock price is closest to:
A) $2.00
B) $3.55
C) $3.87
D) $4.00
Which of the following statements is false?
A) A portfolio that consists of a long position in the risk-free investment is known as a
levered portfolio.
B) The optimal portfolio will not depend on the investor’s personal tradeoff between
risk and return.
C) The volatility of the risk-free investment is zero.
D) Our total volatility is only a fraction of the volatility of the efficient portfolio, based
on the amount we invest in the risk free asset.
Which of the following statements is false?
A) Most projects will require the firm to invest in net working capital.
B) The main components of net working capital are cash, inventory, receivables, and
property, plant and equipment.
C) ΔNWCt = NWCt – NWCt – 1.
D) In the final year of a project, the firm ultimately recovers the investment in net
working capital.
If a bond is currently trading at its face (par) value, then it must be the case that
A) the bond’s yield to maturity is less than its coupon rate.
B) the bond’s yield to maturity is equal to its coupon rate.
C) the bond’s yield to maturity is greater than its coupon rate.
D) the bond is a zero-coupon bond.
Which of the following statements is false?
A) It is tempting to use the Black-Scholes formula to value future growth options, but
often there are good reasons why this formula might not price these options correctly.
B) When a firm has a real option to invest in the future it is known as a growth option.
C) Because growth options have value, they contribute to the value of any firm that has
future possible investment opportunities.
D) Future growth opportunities can be thought of as a collection of real put options on
potential projects.
Use the figure for the question(s) below.
Which of the following statements regarding timelines is false?
A) Timelines are an important first step in organizing and then solving a financial
problem.
B) We refer to a series of cash flows lasting several periods as a stream of cash flows.
C) Not every stream of cash flows can be represented on a timeline.
D) A timeline is a linear representation of the timing of the (expected) cash flows.
Because debtor-in-possession (DIP) financing is senior to all existing creditors,
A) it allows a firm that has filed for bankruptcy renewed access to financing to keep
operating.
B) it is an important cost for firms that rely heavily on trade credit.
C) it is likely to be small for producers of raw materials, as the value of those goods,
once delivered, does not depend on the seller’s continued success.
D) it allows debtors to assume they may have an opportunity to avoid their obligations
to a firm.
Which of the following statements is false?
A) Securities that tend to move more than the market have betas higher than 0.
B) Securities whose returns tend to move in tandem with the market on average have a
beta of 1.
C) Beta corresponds to the slope of the best fitting line in the plot of the securities
excess returns versus the market excess return.
D) The statistical technique that identifies the bets-fitting line through a set of points is
called linear regression.
An asset-backed security backed by home mortgages is a
A) mortgage-backed security.
B) primary home-backed security.
C) bond-backed security.
D) real estate-backed security.
The cash conversion cycle (CCC)is defined as
A) Inventory Days + Accounts Receivable Days – Accounts Payable Days.
B) Inventory Days – Accounts Receivable Days – Accounts Payable Days.
C) Inventory Days + Accounts Receivable Days + Accounts Payable Days.
D) Inventory Days + Accounts Payable Days – Accounts Receivable Days.
Which of the following statements is false?
A) While debt itself may be cheap, it increases the risk and therefore the cost of capital
of the firm’s equity.
B) Although debt does not have a lower cost of capital than equity, we can consider this
cost in isolation.
C) We can use Modigliani and Miller’s first proposition to derive an explicit
relationship between leverage and the equity cost of capital.
D) The total market value of the firm’s securities is equal to the market value of its
assets, whether the firm is unlevered or levered.
Kinston Industries has an average accounts payable balance of $220,000. Its annual cost
of goods sold is $5,475,000, and it receives terms of 2/10, net 30 from its suppliers.
Kinston chooses to forgo this discount. Is Kinston managing its accounts payables well?
Suppose that the risk-free rate is 5% and the market portfolio has an expected return of
13% with a volatility of 18%. Luther Industries has a volatility of 24% and a correlation
with the market of .5. If you assume that the CAPM assumptions hold, then what is the
expected return on Luther stock?
Use the information for the question(s) below.
Consider the following tax rates:
*The current tax rates are set to expire in 2008 unless Congress extends them. The tax
rates shown are for financial assets held for one year. For assets held less than one year,
capital gains are taxed at the ordinary income tax rate (currently 35% for the highest
bracket); the same is true for dividends if the assets are held for less than 61 days.
Using the available tax information for 2002, calculate the effective dividend tax rate
for a:
(1> one-year individual investor
(2> buy and hold individual investor
(3> pension fund
You are long both a put option and a call option on Rockwood stock with the same
expiration date. The exercise price of the call option is $40 and the exercise price of the
put option is $30. Graph the payoff of the combination of options at expiration.
Can the nominal interest rate ever be negative? Can the real interest rate ever be
negative? Explain.
Use the table for the question(s) below.
Consider the following three individuals portfolios consisting of investments in four
stocks:
Assuming that the risk-free rate is 4% and the expected return on the market is 12%,
then calculate the required return on Mary’s portfolio.
Describe the four characteristics of IPOs that puzzle financial economists.
Use the table for the question(s) below.
Consider the following returns:
Calculate the covariance between Stock Y’s and Stock Z’s returns.
Use the information for the question(s) below.
The Aardvark Corporation is considering launching a new product and is trying to
determine an appropriate discount rate for evaluating this new product. Aardvark has
identified the following information for three single division firms that offer products
similar to the one Aardvark is interested in launching:
Based upon the three comparable firms, calculate that most appropriate unlevered cost
of capital for Aardvark to use on this new product.
Two separate firms are considering investing in this project. Firm unlevered plans to
fund the entire $80,000 investment using equity, while firm levered plans to borrow
$45,000 at the risk-free rate and use equity to finance the remainder of the initial
investment. Calculate the risk premiums for both the levered and unlevered firm.
The quarterly working capital levels for Hasbeen Toys are presented in the following
table (in $ millions):
Calculate the temporary working capital needs for each of the four quarters for Hasbeen
Toys.
Use the information for the question(s) below.
KT Enterprises has just issued a callable (at par) fifteen-year, 7% coupon bond with
semiannual coupon payments. The bond can be called at par in five years or anytime
thereafter on a coupon payment date. It has a current price of 101.
What is the Yield to Maturity (YTM) on this bond?
Use the table for the question(s) below.
Consider an ETF that is made up of one share each of IBM, MRK, and C. The current
quote for this ETF currently is $163.15 (bid) $163.20 (ask). What should you do?
Use the table for the question(s) below.
Suppose the term structure of interest rates is shown below:
After examining the yield curve, what predictions do you have about interest rates in
the future? About future economic growth and the overall state of the economy?
Use the information for the question(s) below.
Iota Industries is an all-equity firm with 50 million shares outstanding. Iota has $200
million in cash and expects future free cash flows of $75 million per year. Management
plans to use the cash to expand the firm’s operations, which in turn will increase future
free cash flows by 12%. Iota’s cost of capital is 10% and assume that capital markets are
perfect.
Suppose that Iota is able to invest the $200 million in excess cash into a project that will
increase future free cash flows by 30% If you were advising the board, what course of
action would you recommend, investing the $200 million in an expansion project that
will raise future free cash flows by 30% or use the $200 million to repurchase shares?
Which provides the higher stock price?
If its YTM does not change, how does a bond’s cash price change between coupon
payments?
Describe the conditions when it would be optimal to exercise an American Call and an
American Put option prior to their expiration.
Consider the following balance sheet:
If on December 31, 2008 Luther has 8 million shares outstanding trading at $15 per
share., then what is Luther’s enterprise value?
Use the information for the question(s) below.
Omicron Industries’ Market Value Balance Sheet ($ Millions) and Cost of Capital
Omicron Industries New Project Free Cash Flows
Assume that this new project is of average risk for Omicron and that the firm wants to
hold constant its debt to equity ratio.
Calculate the present value of the interest tax shield provided by Omicron’s new project.
