1) Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the
cost of common equity. The yield on the firm’s bonds is 8.75%, and your firm’s
economists believe that the cost of common can be estimated using a risk premium of
3.85% over a firm’s own cost of debt. What is an estimate of the firm’s cost of common
from reinvested earnings?
a.12.60%
b.13.10%
c.13.63%
d.14.17%
e.14.74%
2) Markman & Sons is considering Projects S and L. These projects are mutually
exclusive, equally risky, and not repeatable and their cash flows are shown below. If the
decision is made by choosing the project with the higher IRR, how much value will be
forgone? Note that under certain conditions choosing projects on the basis of the IRR
will not cause any value to be lost because the project with the higher IRR will also
have the higher NPV, i.e., no conflict will exist.
WACC:10.00%
Year01234
CFS-$1,025$650$450$250 $50
CFL-$1,025$100$300$500$700
a.$5.47
b.$6.02
c.$6.62
d.$7.29
e.$7.82
3) Which of the following statements is CORRECT?
a.The factors that affect a firm’s business risk are affected by industry characteristics
and economic conditions. Unfortunately, these factors are generally beyond the control
of the firm’s management
b.One of the benefits to a firm of being at or near its target capital structure is that this
eliminates any risk of bankruptcy
c.A firm’s financial risk can be minimized by diversification
d.The amount of debt in its capital structure can under no circumstances affect a
company’s business risk
e.A firm’s business risk is determined solely by the financial characteristics of its
industry
4) Which of the following actions would be likely to shorten the cash conversion cycle?
a.Change the credit terms offered to customers from 3/10 net 30 to 1/10 net 50
b.Begin to take discounts on inventory purchases; we buy on terms of 2/10 net 30
c.Adopt a new manufacturing process that saves some labor costs but slows down the
conversion of raw materials to finished goods from 10 days to 20 days
d.Change the credit terms offered to customers from 2/10 net 30 to 1/10 net 60
e.Adopt a new manufacturing process that speeds up the conversion of raw materials to
finished goods from 20 days to 10 days
5) McLeod Inc. is considering an investment that has an expected return of 15% and a
standard deviation of 10%. What is the investment’s coefficient of variation?
a.0.67
b.0.73
c.0.81
d.0.89
e.0.98
6) Bostian, Inc. has total assets of $625,000. Its total debt outstanding is $185,000. The
Board of Directors has directed the CFO to move towards a debt-to-assets ratio of 55%.
How much debt must the company add or subtract to achieve the target debt ratio?
a. $158,750
b. $166,688
c. $175,022
d. $183,773
e. $192,962
7) Refer to Exhibit 15.1. Assume that PP is considering changing from its original
capital structure to a new capital structure with 35% debt and 65% equity. This results
in a weighted average cost of capital equal to 9.4% and a new value of operations of
$510,638. Assume PP raises $178,723 in new debt and purchases T-bills to hold until it
makes the stock repurchase. PP then sells the T-bills and uses the proceeds to
repurchase stock. How many shares remain after the repurchase, and what is the stock
price per share immediately after the repurchase?
a.7,500; $71.49
b.7,000; $59.57
c.6,500; $51.06
d.6,649; $53.33
e.6,959; $58.78
8) Noddings Inc. needs to raise more capital because its business is booming. The
company purchases supplies on terms of 1/10 net 20, and it currently takes the discount.
One way of getting the needed funds would be to forgo the discount, and the firm’s
owner believes she could delay payment to 40 days without adverse effects. What
would be the effective annual percentage cost of funds raised by this action? (Assume a
365-day year.)
a.10.59%
b.11.15%
c.11.74%
d.12.36%
e.13.01%
9) The following information has been presented to you about the Gibson Corporation.
Total assets$3,000 millionTax rate40%
Operating income (EBIT)$800 millionDebt ratio0%
Interest expense$0 millionWACC10%
Net income$480 millionM/B ratio1.00
Share price$32.00EPS = DPS$3.20
The company has no growth opportunities (g = 0), so the company pays out all of its
earnings as dividends (EPS = DPS). The consultant believes that if the company moves
to a capital structure financed with 20% debt and 80% equity (based on market values)
that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%.
If the company makes this change, what would be the total market value (in millions) of
the firm?
a.$3,200
b.$3,600
c.$4,000
d.$4,200
e.$4,800
10) Summary balance sheet data for Greener Gardens Co. is shown below (in thousands
of dollars). The company is in a highly seasonal business, and the data show its assets
and liabilities at peak and off-peak seasons:
PeakOff-Peak
Cash$ 50$ 30
Marketable securities020
Accounts receivable4020
Inventories10050
Net fixed assets 500 500
Total assets$690$620
Payables and accruals$ 30$ 10
Short-term bank debt500
Long-term debt300300
Common equity 310 310
Total claims$690$620
From this data we may conclude that
a.Greener Gardens’ current asset financing policy is relatively aggressive; that is, the
company finances some of its permanent assets with short-term discretionary debt
b.Greener Gardens follows a relatively conservative approach to current asset
financing; that is, some of its short-term needs are met by permanent capital
c.Without income statement data, we cannot determine the aggressiveness or
conservatism of the company’s current asset financing policy
d.Without cash flow data, we cannot determine the aggressiveness or conservatism of
the company’s current asset financing policy
e.Greener Gardens’ current asset financing policy calls for exactly matching asset and
liability maturities
11) Which of the following statements is NOT CORRECT?
a.The corporate valuation model discounts free cash flows by the required return on
equity
b.The corporate valuation model can be used to find the value of a division
c.An important step in applying the corporate valuation model is forecasting the firm’s
pro forma financial statements
d.Free cash flows are assumed to grow at a constant rate beyond a specified date in
order to find the horizon, or terminal, value
e.The corporate valuation model can be used both for companies that pay dividends and
those that do not pay dividends
12) Which of the following statements is CORRECT?
a.If a project has “normal” cash flows, then its MIRR must be positive
b.If a project has “normal” cash flows, then it will have exactly two real IRRs
c.The definition of “normal” cash flows is that the cash flow stream has one or more
negative cash flows followed by a stream of positive cash flows and then one negative
cash flow at the end of the project’s life
d.If a project has “normal” cash flows, then it can have only one real IRR, whereas a
project with “nonnormal” cash flows might have more than one real IRR
e.If a project has “normal” cash flows, then its IRR must be positive
13) Which of the following statements is CORRECT?
a.Long-term bonds have less interest rate price risk but more reinvestment rate risk than
short-term bonds
b.If interest rates increase, all bond prices will increase, but the increase will be greater
for bonds that have less interest rate risk
c.Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has
more interest rate price risk but less reinvestment rate risk
d.Long-term bonds have less interest rate price risk and also less reinvestment rate risk
than short-term bonds
e.One advantage of a zero coupon Treasury bond is that no one who owns the bond has
to pay any taxes on it until it matures or is sold
14) Kinkead Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will
be -$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected
to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%,
what is the firm’s value of operations, in millions?
a.$158
b.$167
c.$175
d.$184
e.$193
15) Which of the following statements is CORRECT? As a firm increases the operating
leverage used to produce a given quantity of output, this will
a.normally lead to a decrease in its business risk
b.normally lead to a decrease in the standard deviation of its expected EBIT
c.normally lead to a decrease in the variability of its expected EPS
d.normally lead to a reduction in its fixed assets turnover ratio
e.normally lead to an increase in its fixed assets turnover ratio
16) As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common
equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and
g = 8.00% (constant). Based on the DCF approach, what is the cost of common from
reinvested earnings?
a.10.69%
b.11.25%
c.11.84%
d.12.43%
e.13.05%
17) Which of the following would be most likely to occur in the year after Congress, in
an effort to increase tax revenue, passed legislation that forced companies to depreciate
equipment over longer lives? Assume that sales, other operating costs, and tax rates are
not affected, and assume that the same depreciation method is used for tax and
stockholder reporting purposes.
a.Companies’ reported net incomes would decline
b.Companies’ net operating profits after taxes (NOPAT) would decline
c.Companies’ physical stocks of fixed assets would increase
d.Companies’ net cash flows would increase
e.Companies’ cash positions would decline
18) Refer to Exhibit 15.2. If this plan were carried out, what would be VF’s new WACC
and its new value of operations?
WACC Value
a.9.64% $497,925
b.9.83% $507,884
c.10.03% $518,041
d.10.23% $528,402
e.10.74% $538,970
19) Which of the following statements is most consistent with efficient inventory
management? The firm has a
a.low incidence of production schedule disruptions
b.below average total assets turnover ratio
c.relatively high current ratio
d.relatively low DSO
e.below average inventory turnover ratio
20) If the CEO of a large, diversified, firm were filling out a fitness report on a division
manager (i.e., “grading” the manager), which of the following situations would be likely
to cause the manager to receive a better grade? In all cases, assume that other things are
held constant.
a. The division’s DSO (days’ sales outstanding) is 40, whereas the average for its
competitors is 30
b. The division’s basic earning power ratio is above the average of other firms in its
industry
c. The division’s total assets turnover ratio is below the average for other firms in its
industry
d. The division’s debt ratio is above the average for other firms in the industry
e. The division’s inventory turnover is 6, whereas the average for its competitors is 8
21) A company expects sales to increase during the coming year, and it is using the
AFN equation to forecast the additional capital that it must raise. Which of the
following conditions would cause the AFN to increase?
a.The company increases its dividend payout ratio
b.The company begins to pay employees monthly rather than weekly
c.The company’s profit margin increases
d.The company decides to stop taking discounts on purchased materials
e.The company previously thought its fixed assets were being operated at full capacity,
but now it learns that it actually has excess capacity
22) The Tierney Group has two divisions of equal size: an office furniture
manufacturing division and a data processing division. Its CFO believes that
stand-alone data processor companies typically have a WACC of 9%, while stand-alone
furniture manufacturers typically have a 13% WACC. She also believes that the data
processing and manufacturing divisions have the same risk as their typical peers.
Consequently, she estimates that the composite, or corporate, WACC is 11%. A
consultant has suggested using a 9% hurdle rate for the data processing division and a
13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she
has assigned an 11% WACC to all projects in both divisions. Which of the following
statements is CORRECT?
a.The decision not to adjust for risk means, in effect, that it is favoring the data
processing division. Therefore, that division is likely to become a larger part of the
consolidated company over time
b.The decision not to adjust for risk means that the company will accept too many
projects in the manufacturing division and too few in the data processing division. This
will lead to a reduction in the firm’s intrinsic value over time
c.The decision not to risk-adjust means that the company will accept too many projects
in the data processing business and too few projects in the manufacturing business. This
will lead to a reduction in its intrinsic value over time
d.The decision not to risk-adjust means that the company will accept too many projects
in the manufacturing business and too few projects in the data processing business. This
may affect the firm’s capital structure but it will not affect its intrinsic value
e.While the decision to use just one WACC will result in its accepting more projects in
the manufacturing division and fewer projects in its data processing division than if it
followed the consultant’s recommendation, this should not affect the firm’s intrinsic
value
23) Laramie Labs uses a risk-adjustment when evaluating projects of different risk. Its
overall (composite) WACC is 10%, which reflects the cost of capital for its average
asset. Its assets vary widely in risk, and Laramie evaluates low-risk projects with a
WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The
company is considering the following projects:
ProjectRiskExpected Return
AHigh15%
BAverage12%
CHigh11%
DLow 9%
ELow 6%
Which set of projects would maximize shareholder wealth?
a.A and B
b.A, B, and C
c.A, B, and D
d.A, B, C, and D
e.A, B, C, D, and E
24) The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50%
required return. The risk-free rate is 4.20%. Henry now receives another $5.00 million,
which he invests in stocks with an average beta of 0.65. What is the required rate of
return on the new portfolio? (Hint: You must first find the market risk premium, then
find the new portfolio beta.)
a.8.83%
b.9.05%
c.9.27%
d.9.51%
e.9.74%
25) Victor Rumsfeld Inc.’s dividend policy is under review by its board. Its projected
capital budget is $2,000,000, its target capital structure is 60% debt and 40% equity, and
its forecasted net income is $600,000. If the company follows a residual dividend
policy, what total dividends, if any, will it pay out?
a. $240,000
b. $228,000
c. $216,600
d. $205,770
e. $0
26) Sentry Corp. bonds have an annual coupon payment of 7.25%. The bonds have a
par value of $1,000, a current price of $1,125, and they will mature in 13 years. What is
the yield to maturity on these bonds?
a.5.56%
b.5.85%
c.6.14%
d.6.45%
e.6.77%
27) Which of the following statements is CORRECT?
a.One defect of the IRR method is that it does not take account of the time value of
money
b.One defect of the IRR method is that it does not take account of the cost of capital
c.One defect of the IRR method is that it values a dollar received today the same as a
dollar that will not be received until sometime in the future
d.One defect of the IRR method is that it assumes that the cash flows to be received
from a project can be reinvested at the IRR itself, and that assumption is often not valid
e.One defect of the IRR method is that it does not take account of cash flows over a
project’s full life
28) Nikko Corp.’s total common equity at the end of last year was $305,000 and its net
income after taxes was $60,000. What was its ROE?
a. 16.87%
b. 17.75%
c. 18.69%
d. 19.67%
e. 20.66%
29) Assume that a 10-year Treasury bond has a 12% annual coupon, while a 15-year
T-bond has an 8% annual coupon. Assume also that the yield curve is flat, and all
Treasury securities have a 10% yield to maturity. Which of the following statements is
CORRECT?
a.If interest rates decline, the prices of both bonds will increase, but the 10-year bond
would have a larger percentage increase in price
b.The 10-year bond would sell at a discount, while the 15-year bond would sell at a
premium
c.The 10-year bond would sell at a premium, while the 15-year bond would sell at par
d.If the yield to maturity on both bonds remains at 10% over the next year, the price of
the 10-year bond would increase, but the price of the 15-year bond would fall
e.If interest rates decline, the prices of both bonds will increase, but the 15-year bond
would have a larger percentage increase in price
ANS:E
We can tell by inspection that b, c, and d are all incorrect. That leaves answers a and e
as the only possibly correct statements. Also, recognize that longer-term bonds, and
ones where payments come late (like low coupon bonds) are most sensitive to changes
in interest rates. Thus, the 15-year, 8% coupon bond should be more sensitive to a
decline in rates. Finally, we can do some calculations to confirm that e is the correct
30) Which of the following statements is CORRECT?
a.If you found a stock with a zero historical beta and held it as the only stock in your
portfolio, you would by definition have a riskless portfolio
b.The beta coefficient of a stock is normally found by regressing past returns on a stock
against past market returns. One could also construct a scatter diagram of returns on the
stock versus those on the market, estimate the slope of the line of best fit, and use it as
beta. However, this historical beta may differ from the beta that exists in the future
c.The beta of a portfolio of stocks is always larger than the betas of any of the
individual stocks
d.It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta
of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free
(default-free) rate of return, rRF
e.The beta of a portfolio of stocks is always smaller than the betas of any of the
individual stocks
31) The CEO of Harding Media Inc. as asked you to help estimate its cost of common
equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00%
(constant). The CEO thinks, however, that the stock price is temporarily depressed, and
that it will soon rise to $40.00. Based on the DCF approach, by how much would the
cost of common from reinvested earnings change if the stock price changes as the CEO
expects?
a.-1.49%
b.-1.66%
c.-1.84%
d.-2.03%
e.-2.23%
32) Cartwright Communications is considering making a change to its capital structure
to reduce its cost of capital and increase firm value. Right now, Cartwright has a capital
structure that consists of 20% debt and 80% equity, based on market values. (Its D/S
ratio is 0.25.) The risk-free rate is 6% and the market risk premium, rM – rRF, is 5%.
Currently the company’s cost of equity, which is based on the CAPM, is 12% and its tax
rate is 40%. What would be Cartwright’s estimated cost of equity if it were to change its
capital structure to 50% debt and 50% equity?
a.13.00%
b.13.64%
c.14.35%
d.14.72%
e.15.60%
33) Reinegar Corporation is planning two new issues of 25-year bonds. Bond Par will
be sold at its $1,000 par value, and it will have a 10% semiannual coupon. Bond OID
will be an Original Issue Discount bond, and it will also have a 25-year maturity and a
$1,000 par value, but its semiannual coupon will be only 6.25%. If both bonds are to
provide investors with the same effective yield, how many of the OID bonds must
Reinegar issue to raise $3,000,000? Disregard flotation costs, and round your final
answer up to a whole number of bonds.
a.4,228
b.4,337
c.4,448
d.4,562
e.4,676
34) A box of chocolate candy costs 28.80 Swiss francs in Switzerland and $20 in the
United States. Assuming that purchasing power parity (PPP) holds, what is the current
exchange rate?
a.1 U.S. dollar equals 0.69 Swiss francs
b.1 U.S. dollar equals 0.85 Swiss francs
c.1 U.S. dollar equals 1.21 Swiss francs
d.1 U.S. dollar equals 1.29 Swiss francs
e.1 U.S. dollar equals 1.44 Swiss francs
35) Refer to Exhibit 15.4. The firm is considering moving to a capital structure that is
comprised of 40% debt and 60% equity, based on market values. The new funds would
be used to replace the old debt and to repurchase stock. It is estimated that the increase
in risk resulting from the additional leverage would cause the required rate of return on
debt to rise to 7%, while the required rate of return on equity would rise to 9.5%. If this
plan were carried out, what would be AJC’s new WACC and total value?
a.7.38%; $800,008
b.7.38%; $813,008
c.7.50%; $813,008
d.7.50%; $790,008
e.7.80%; $790,008
36) Tallant Technologies is considering two potential projects, X and Y. In assessing the
projects’ risks, the company estimated the beta of each project versus both the
company’s other assets and the stock market, and it also conducted thorough scenario
and simulation analyses. This research produced the following data:
Project XProject Y
Expected NPV$500,000$500,000
Standard deviation (sNPV)$200,000$250,000
Project beta (vs. market)1.40.8
Correlation of the project cash flows with cash flows from currently existing projects.
Cash flows are not correlated with the cash flows from existing projects. Cash flows are
highly correlated with the cash flows from existing projects.
Which of the following statements is CORRECT?
a.Project X has more corporate (or within-firm) risk than Project Y
b.Project X has more market risk than Project Y
c.Project X has the same level of corporate risk as Project Y
d.Project X has less market risk than Project Y
e.Project X has more stand-alone risk than Project Y
37) Which of the following would be most likely to lead to higher interest rates on all
debt securities in the economy?
a. Households start saving a larger percentage of their income
b. The economy moves from a boom to a recession
c. The level of inflation begins to decline
d. Corporations step up their expansion plans and thus increase their demand for capital
e. The Federal Reserve uses monetary policy in an attempt to stimulate the economy
38) Which of the following statements is CORRECT?
a.In a capital budgeting analysis where part of the funds used to finance the project
would be raised as debt, failure to include interest expense as a cost when determining
the project’s cash flows will lead to a downward bias in the NPV
b.The existence of any type of “externality” will reduce the calculated NPV versus the
NPV that would exist without the externality
c.If one of the assets to be used by a potential project is already owned by the firm, and
if that asset could be sold or leased to another firm if the new project were not
undertaken, then the net after-tax proceeds that could be obtained should be charged as
a cost to the project under consideration
d.If one of the assets to be used by a potential project is already owned by the firm but
is not being used, then any costs associated with that asset is a sunk cost and should be
ignored
e.In a capital budgeting analysis where part of the funds used to finance the project
would be raised as debt, failure to include interest expense as a cost when determining
the project’s cash flows will lead to an upward bias in the NPV
39) The graphical probability distribution of ROE for a firm that uses financial leverage
would tend to be more peaked than the distribution if the firm used no leverage, other
things held constant.
40) Even if a stock split has no information content, and even if the dividend per share
adjusted for the split is not increased, there can still be a real benefit (i.e., a higher value
for shareholders) from such a split, but any such benefit is probably small.
41) If an investor buys enough stocks, he or she can, through diversification, eliminate
all of the market risk inherent in owning stocks, but as a general rule it will not be
possible to eliminate all diversifiable risk.
42) Ratio analysis involves analyzing financial statements in order to appraise a firm’s
financial position and strength.
43) If a firm switched from taking trade credit discounts to paying on the net due date,
this might cost the firm some money, but such a policy would probably have only a
negligible effect on the income statement and no effect whatever on the balance sheet.
44) Founders’ shares are a type of classified stock where the shares are owned by the
firm’s founders, and they generally have more votes per share than the other classes of
common stock.
45) As long as a firm does not pay out 100% of its earnings, the firm’s annual profit that
is retained in the business (i.e., the addition to retained earnings) is another source of
funds for a firm’s expansion.
46) Financial risk refers to the extra risk stockholders bear as a result of using debt as
compared with the risk they would bear if no debt were used.