Suppose Firms A and B have the same amount of assets, total assets are equal to total
invested capital, pay the same interest rate on their debt, have the same basic earning
power (BEP), finance with only debt and common equity, and have the same tax rate.
However, Firm A has a higher debt to capital ratio. If BEP is greater than the interest
rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.
a.True
b.False
Which of the following statements is CORRECT?
a.Shorter-term cash budgets, in general, are used primarily for planning purposes, while
longer-term budgets are used for actual cash control.
b.The cash budget and the capital budget are developed separately, and although they
are both important to the firm, one does not affect the other.
c.Since depreciation is a non-cash charge, it neither appears on nor has any effect on the
cash budget.
d.The target cash balance should be set such that it need not be adjusted for seasonal
patterns and unanticipated fluctuations in receipts, although it should be changed to
reflect long-term changes in the firm’s operations.
e.The typical cash budget reflects interest paid on loans as well as income from the
investment of surplus cash. These numbers, as well as other items on the cash budget,
are expected values; hence, actual results might vary from the budgeted amounts.
Which of the following statements is CORRECT?
a.Trade credit is provided only to relatively large, strong firms.
b.Commercial paper is a form of short-term financing that is primarily used by large,
strong, financially stable companies.
c.Short-term debt is favored by firms because, while it is generally more expensive than
long-term debt, it exposes the borrowing firm to less risk than long-term debt.
d.Commercial paper can be issued by virtually any firm so long as it is willing to pay
the going interest rate.
e.Commercial paper is typically offered at a long-term maturity of at least five years.
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.
Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard
deviation of 25%, and their returns are independent of one another, i.e., the correlation
coefficients between each pair of stocks is zero. Assuming the market is in equilibrium,
which of the following statements is CORRECT?
a.Portfolio P’s expected return is greater than the expected return on Stock B.
b.Portfolio P’s expected return is equal to the expected return on Stock A.
c.Portfolio P’s expected return is less than the expected return on Stock B.
d.Portfolio P’s expected return is equal to the expected return on Stock B.
e.Portfolio P’s expected return is greater than the expected return on Stock C.
Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and
a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested
in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT?
(Assume that the stocks are in equilibrium.)
a.Stock A’s returns are less highly correlated with the returns on most other stocks than
are B’s returns.
b.Stock B has a higher required rate of return than Stock A.
c.Portfolio P has a standard deviation of 22.5%.
d.More information is needed to determine the portfolio’s beta.
e.Portfolio P has a beta of 1.0.
The “degree of leverage” concept is designed to show how changes in sales will affect
EBIT and EPS. If a 10% increase in sales causes EPS to increase from $1.00 to $1.50,
and if the firm uses no debt, then what is its degree of operating leverage?
a.4.2869
b.4.5125
c.4.7500
d.5.0000
e.5.2500
Northern Conglomerate has two divisions, Division A and Division B. Northern looks
at competing pure-play firms to estimate the betas of each of the two divisions. After
this analysis, Northern concludes that Division A has a beta of 0.8 and Division B has a
beta of 1.5. The two divisions are the same size. The risk-free rate is 5% and the market
risk premium is 6%. Assume that Northern is 100% equity financed. What is the overall
composite WACC for Northern Conglomerate?
a.10.74%
b.11.31%
c.11.90%
d.12.50%
e.13.12%
Casey Motors recently reported the following information:
Net income = $600,000.
Tax rate = 40%.
Interest expense = $200,000.
Total invested operating capital employed = $9 million.
After-tax cost of capital = 10%.
What is the company’s EVA?
a.-$171,000
b.-$180,000
c.-$189,000
d.-$198,450
e.-$208,373
Exhibit 7A.1
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will
yield its first positive cash flow in 3 years. That cash flow will be sufficient to pay off
the entire debt issue. The bond’s par value will be $1,000, it will mature in 3 years, and
it will sell in the market for $727.25. The firm’s marginal tax rate is 40%.
Refer to Exhibit 7A.1. What is the nominal dollar value of the interest tax savings to the
firm in the third year of the issue?
a.$38.27
b.$40.29
c.$42.30
d.$44.42
e.$46.64
Which of the following statements is CORRECT?
a.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.
b.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.
c.Because of the costs of granting credit, it is not possible for credit sales to be more
profitable than cash sales.
d.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.
e.Other things held constant, if a firm can shorten its DSO, this will lead to a higher
current ratio.
Which of the following is NOT a potential problem when estimating and using betas,
i.e., which statement is FALSE?
a.The fact that a security or project may not have a past history that can be used as the
basis for calculating beta.
b.Sometimes, during a period when the company is undergoing a change such as toward
more leverage or riskier assets, the calculated beta will be drastically different from the
“true” or “expected future” beta.
c.The beta of an “average stock,” or “the market,” can change over time, sometimes
drastically.
d.Sometimes the past data used to calculate beta do not reflect the likely risk of the firm
for the future because conditions have changed.
e.The beta coefficient of a stock is normally found by regressing past returns on a stock
against past market returns. This calculated historical beta may differ from the beta that
exists in the future.
At the beginning of the year Giant Inc.’s management is considering making an offer to
buy Micro Corporation. Micro’s projected operating income (EBIT) for the current year
is $30 million, but Giant believes that if the two firms were merged, it could consolidate
some operations, reduce Micro’s expenses, and raise its EBIT to $35 million. Neither
company uses any debt, and they both pay income taxes at a 35% rate. Giant has a
better reputation among investors, who regard it as very well managed and not very
risky, so its stock has a P/E ratio of 12 versus a P/E of 9 for Micro. Since Giant’s
management would be running the entire enterprise after a merger, investors would
value the resulting corporation based on Giant’s P/E. If Micro has 10 million shares
outstanding, by how much should the merger increase its share price, assuming all of
the synergy will go to its stockholders?
a.$7.94
b.$8.36
c.$8.80
d.$9.26
e.$9.75
Herring Corporation has operating income of $225,000 and a 40% tax rate. The firm
has short-term debt of $120,000, long-term debt of $330,000, and common equity of
$450,000. What is its return on invested capital?
a.13.75%
b.14.33%
c.15.00%
d.16.25%
e.17.10%
Net operating working capital is equal to current assets minus the difference between
current liabilities and notes payable. This definition assumes that the firm has no
“excess” cash.
a.True
b.False
Below is the common equity section (in millions) of Timeless Technology’s last two
year-end balance sheets:
The firm has never paid a dividend to its common stockholders. Which of the following
statements is CORRECT?
a.The company’s net income in 2014 was higher than in 2013.
b.The firm issued common stock in 2014.
c.The market price of the firm’s stock doubled in 2014.
d.The firm had positive net income in both 2013 and 2014, but its net income in 2014
was lower than it was in 2013.
e.The company has more equity than debt on its balance sheet.
Sunshine Inc. has two equally-sized divisions. Division A has a beta of 0.8 and Division
B has a beta of 2. The company is 100% equity financed. The risk-free rate is 6% and
the market risk premium is 5%. Sunshine assigns different hurdle rates to each division
based on each division’s market risk. Which of the following statements is CORRECT?
a.Sunshine’s composite WACC is 10%.
b.Division B has a lower WACC than Division A.
c.If the same WACC is used for each division, the firm would select too many Division
A projects and reject too many Division B projects.
d.If the same WACC is used for each division, the firm would select too many Division
B projects and reject too many Division A projects.
e.Sunshine’s composite WACC is 12%.
Moose Industries faces the following tax schedule:
Last year the company realized $10,000,000 in operating income (EBIT). Its annual
interest expense is $1,500,000. What was the company’s net income for the year?
a.$4,809,874
b.$5,063,025
c.$5,329,500
d.$5,610,000
e.$5,890,500
Which of the following statements concerning the cash budget is CORRECT?
a.Depreciation expense is not explicitly included, but depreciation’s effects are reflected
in the estimated tax payments.
b.Cash budgets do not include financial items such as interest and dividend payments.
c.Cash budgets do not include cash inflows from long-term sources such as the issuance
of bonds.
d.Changes that affect the DSO do not affect the cash budget.
e.Capital budgeting decisions have no effect on the cash budget until projects go into
operation and start producing revenues.
Which of the following statements is CORRECT?
a.An investor can eliminate virtually all market risk if he or she holds a very large and
well diversified portfolio of stocks.
b.The higher the correlation between the stocks in a portfolio, the lower the risk
inherent in the portfolio.
c.It is impossible to have a situation where the market risk of a single stock is less than
that of a portfolio that includes the stock.
d.Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk
by even a small amount.
e.An investor can eliminate virtually all diversifiable risk if he or she holds a very large,
well-diversified portfolio of stocks.
Which of the following methods involves calculating an average beta for comparable
firms and using that beta to determine a project’s beta?
a.Risk premium method
b.Pure play method
c.Accounting beta method
d.CAPM method
e.Discounted cash flow model