Business risk is affected by a firm’s operations. Which of the following is NOT directly
associated with (or does not directly contribute to) business risk?
a.Demand variability.
b.Sales price variability.
c.The extent to which operating costs are fixed.
d.The extent to which interest rates on the firm’s debt fluctuate.
e.Input price variability.
A riskless hedge can best be defined as
a.A situation in which aggregate risk can be reduced by derivatives transactions
between two parties.
b.A hedge in which an investor buys a stock and simultaneously sells a call option on
that stock and ends up with a riskless position.
c.Standardized contracts that are traded on exchanges and are “marked to market” daily,
but where physical delivery of the underlying asset is virtually never taken.
d.Two parties agree to exchange obligations to make specified payment streams.
e.Simultaneously buying and selling a call option with the same exercise price.
Alvarez Technologies has sales of $3,000,000. The company’s fixed operating costs
total $500,000 and its variable costs equal 60% of sales, so the company’s current
operating income is $700,000. The company’s interest expense is $500,000. What is the
company’s degree of total leverage (DTL)?
a.4.8870
b.5.1443
c.5.4150
d.5.7000
e.6.0000
Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must
be true, assuming the CAPM is correct.
a.Stock A would be a more desirable addition to a portfolio then Stock B.
b.In equilibrium, the expected return on Stock B will be greater than that on Stock A.
c.When held in isolation, Stock A has more risk than Stock B.
d.Stock B would be a more desirable addition to a portfolio than A.
e.In equilibrium, the expected return on Stock A will be greater than that on B.
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.Portfolio P has a standard deviation of 25% and a beta of 1.0.
b.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.
c.Portfolio P has more market risk than Stock A but less market risk than B.
d.Stock A should have a higher expected return than Stock B as viewed by the marginal
investor.
e.Portfolio P has a coefficient of variation equal to 2.5.
U.S. Delay Corporation, a subsidiary of the Postal Service, must decide whether to
issue zero coupon bonds or quarterly payment bonds to fund construction of new
facilities. The $1,000 par value quarterly payment bonds would sell at $795.54, have a
10% coupon rate, and mature in 10 years. At what price would the zero coupon bonds
with a maturity of 10 years have to sell to earn the same effective annual rate as the
quarterly payment bonds?
a.$220.77
b.$232.39
c.$244.62
d.$257.50
e.$270.37
Roenfeld Corp believes the following probability distribution exists for its stock. What
is the coefficient of variation on the company’s stock?
a.0.2839
b.0.3069
c.0.3299
d.0.3547
e.0.3813
Companies HD and LD have identical amounts of assets, investor-supplied capital,
operating income (EBIT), tax rates, and business risk. Company HD, however, has a
higher debt ratio than LD. Company HD’s return on investors’ capital (ROIC) exceeds
its after-tax cost of debt, rd(1 – T). Which of the following statements is CORRECT?
a.Company HD has a higher return on assets (ROA) than Company LD.
b.Company HD has a higher times interest earned (TIE) ratio than Company LD.
c.Company HD has a higher return on equity (ROE) than Company LD, and its risk as
measured by the standard deviation of ROE is also higher than LD’s.
d.The two companies have the same ROE.
e.Company HD’s ROE would be higher if it had no debt.
You have the following data on three stocks:
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If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in
isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.
a.A; A.
b.A; B.
c.B; A.
d.C; A.
e.C; B.
Refer to Exhibit 20.1. What is the bond’s straight-debt value at the time of issue?
a.$684.78
b.$720.82
c.$758.76
d.$798.70
e.$838.63
Which of the following statements is CORRECT?
a.Once a firm has defined its purpose, scope, and objectives, it must develop a strategy
or strategies for achieving its goals. The statement of corporate strategies sets forth
detailed plans rather than broad approaches for achieving a firm’s goals.
b.A firm’s corporate purpose states the general philosophy of the business and provides
managers with specific operational objectives.
c.Operating plans provide management with detailed implementation guidance,
consistent with the corporate strategy, to help meet the corporate objectives. These
operating plans can be developed for any time horizon, but many companies use a
5-year horizon.
d.A firm’s mission statement defines its lines of business and geographic area of
operations.
e.The corporate scope is a condensed version of the entire set of strategic plans.
Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%.
Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation
is 15%. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock
B. The correlation between the two stocks’ returns is zero (that is, rA,B = 0). Which of
the following statements is CORRECT?
a.Portfolio AB’s standard deviation is 17.5%.
b.The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B
is overvalued.
c.The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B
is undervalued.
d.Portfolio AB’s expected return is 11.0%.
e.Portfolio AB’s beta is less than 1.2.
Crockett Corporation’s 5-year bonds yield 6.35%, and 5-year T-bonds yield 4.75%. The
real risk-free rate is r* = 3.60%, the default risk premium for Crockett’s bonds is DRP =
1.00% versus zero for T-bonds, the liquidity premium on Crockett’s bonds is LP =
0.90% versus zero for T-bonds, and the maturity risk premium for all bonds is found
with the formula MRP = (t – 1) x 0.1%, where t = number of years to maturity. What
inflation premium (IP) is built into 5-year bond yields?
a.0.68%
b.0.75%
c.0.83%
d.0.91%
e.1.00%
During the coming year, the market risk premium (rM – rRF), is expected to fall, while
the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the
following statements is CORRECT?
a.The required return will increase for stocks with a beta less than 1.0 and will decrease
for stocks with a beta greater than 1.0.
b.The required return on all stocks will remain unchanged.
c.The required return will fall for all stocks, but it will fall more for stocks with higher
betas.
d.The required return for all stocks will fall by the same amount.
e.The required return will fall for all stocks, but it will fall less for stocks with higher
betas.
Consider each of the following bonds:
Bond A:8-year maturity with a 7% annual coupon.
Bond B:10-year maturity with a 9% annual coupon.
Bond C:12-year maturity with a zero coupon.
Each bond has a face value of $1,000 and a yield to maturity of 8%. Which of the
following statements is NOT correct?
a.Bond A sells at a discount, while Bond B sells at a premium.
b.If the yield to maturity on each bond falls to 7%, Bond C will have the largest
percentage increase in its price.
c.Bond C has the most reinvestment risk.
d.Bond C has the most price risk.
e.If the yield to maturity is constant, the price of Bond A will continue to increase over
its life until it finally sells at par.
Which of the following statements is CORRECT?
a.A firm’s business risk is determined solely by the financial characteristics of its
industry.
b.The factors that affect a firm’s business risk include industry characteristics and
economic conditions, both of which are generally beyond the firm’s control.
c.One of the benefits to a firm of being at or near its target capital structure is that this
generally minimizes the risk of bankruptcy.
d.A firm’s financial risk can be minimized by diversification.
e.The amount of debt in its capital structure can under no circumstances affect a
company’s EBIT and business risk.
If management operates in a manner designed to maximize the firm’s expected profits
for the current year, this will also maximize the stockholders’ wealth as of the current
year.
a.True
b.False
C. F. Lee Inc. has the following income statement. How much after-tax operating
income does the firm have?
a.$427.78
b.$450.29
c.$473.99
d.$498.94
e.$525.20
Last year Harrington Inc. had sales of $325,000 and a net income of $19,000, and its
year-end assets were $250,000. The firm’s total-debt-to-total-capital ratio was 45.0%.
The firm finances using only debt and common equity and its total assets equal total
invested capital. Based on the DuPont equation, what was the ROE?
a.13.82%
b.14.51%
c.15.23%
d.16.00%
e.16.80%
